Do CEOs Really Owe Shareholders a Rising Stock Price?

The Great “but” in any discussion of short term profitability versus corporate responsibility, whether to the public or to the company’s own future, is “but CEOs owe it to the shareholders to increase stock price.”

This seemingly iron-clad obligation is arguably the source of much of the financial turmoil of the last couple years, with CEOs at banks and elsewhere so focused on increasing shareholder value (and thus their own bonuses) that they stopped paying attention to the long- or even medium-term health of the company, not to mention its obligation to society at large.

An obviously false assumption

Dean Roger Martin of the Rotman School of Management at the University of Toronto writes in the latest issue of the Harvard Business Review that this belief is based on a false assumption. While the CEO does owe the initial purchasers of stock in a stock offering a return on their investment, they should not feel obligated to increase returns based on a higher stock price.

Martin uses the example of a company that issues stock at $20. With a cost of equity at 10 percent, it theoretically owes initial investors a $2 return on their money. But if, as a result of the CEO’s prudent leadership, the stock price doubles to $40, then there is no reason the company should now owe a 10% return to people who bought at $40.

The fact is, despite their belief to the contrary, neither boards nor management actually owe public shareholders an attractive return on the market value of the stock they purchased.

Think about it: you may have bought Google at $400 a share, but Google shouldn’t be obligated to push it to $600 when they issued it at $85 (but oh do I wish I’d bought then). Yet that is exactly what CEOs and others say to justify sometimes startlingly short-sighted decisions: we owe the shareholders.

A new way at looking at equity

Martin suggests a radically simple adjustment to cure this problem:

In the long run, companies would be healthier and their shareholders better off if their CEOs only sought to earn a return on the capital provided to them by shareholders, i.e. their book capital not their market capital. Enshrining that in the mission statements of America’s corporations would be a great place to start.

It might also strengthen the hand of those who argue that long-term goals–including increased social responsibility–are the key to corporate success. And it could bring some sanity to corporate America in the process.

BC (Ben) Upham is a freelance writer based in Los Angeles. He has written for the New York Times, and was a writer and editor for News Communications, Inc., a local paper consortium serving Manhattan. When he's not blogging on green issues -- and especially renewable energy -- he's hiking in the Angeles Mountains or hanging out at El Matador.

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