Objectives of the Firm

Stakeholders and their interest – in whose interest is the firm run? - The question raised would be either by the interest of the shareholders, or stakeholders. But, in the grand scheme of things, a firm is run with multiple interested parties being the focus. There are customers, creditors, employees, managers, society, and shareholders. However, the main objective of a firm is to meet the desires of the shareholders.

The firm is run based on the interest of the shareholders, as the owners of the firm. But there is a difference between the interest they have, and their pursuit of this. Meaning, in a firm, the shareholders are simply investors, some don’t have the professional knowledge or experience to run a firm – at least, not in the way that would achieve their interests. Therefore, in achieving this, the shareholders employ ‘Managers’ or as we call them ‘Agents’ - where the job of an agent is to align the firm with the interests of the shareholders, however, it does not come without it's challenges because shareholders delegate decision-making to managers, in which a potential conflict of interest arises – known as the agency problem – where managers may pursue their own goals rather than maximising shareholder wealth.

Friedman (1970) encapsulates the principle by imploring managers as shareholders’ agents to: “conduct business in accordance with shareholders’ desires, which will generally be to make as much money as possible while conforming to the basic rules of the society, both those embodied in law, and those embodied in ethical custom”.

Now that we’ve established that the running of a firm is to align with shareholders’ desires, let’s consider how this looks from the financial side. It is assumed that the firm should make investment and financing decisions with the aim of maximising long-term shareholder wealth. But why? Because shareholders take on the risk, so they should get the reward. The more practical reason would be that decision making regarding investments and how the firm is financed, is easier when there is only a single objective to achieve – but can we run a firm like this?

Well, before we can answer that question, we need to look at how maximising shareholder wealth is achieved. The aim of wealth maximisation is to maximise shares price, and dividends – which is commonly measures by total shareholder return (TSR). In which there are two types of returns shareholders can achieve, as mentioned, capital gains from shares price being higher when you sell than when you buy, and dividends.

To put this into perspective, imagine you own 1,000 shares in ABC Plc. You initially paid £2.10 per share on day 0, and that share price rose to £2.40 per share on day 365, and on top of that £0.15 per share was given as a dividend at the end of the financial year too.

• Purchase: (£2.10 * 1,000) = £2,100.
• Selling: (£2.30 * 1,000) = £2,400.
• Dividend: (£0.15 * 1,000) = £150.
• TSR: ((£2,400 - £2,100) + £150) = £450 or 21.42%

Now maximising shareholder wealth is, as we can see, worthwhile, but is there other possible objectives? Historically, profit maximisation was king, but not necessarily in line with shareholder wealth maximisation. What about maximising revenues too?

We see some issues with the objective of profit maximisation, for example;

1. Historic measure: Profit is based on the past performance of the firm, like previous financial statements, whereas, shareholders are interested in the future performance of their returns, not just what’s happened previously. Additionally, last year we may have seen a firm perform extremely well, but if in the current year we see a drop in growth, or demand, the share price is likely to not increase.
2. Accounting Problems: Profit is subjective based on many factors, for one, accounting policies – like depreciation methods, the way we valuate inventory, or recognise our revenue sources. Two firms could make the same level of sales, have the same level of expenses etc, but if they utilise opposing accounting decisions, like mentioned, their performance on paper is different to each other. This ultimately gives insight into the imperfect measure of real economic performance that is the measurement of profit.
3. Communication: The measurement of profit doesn’t give the full story to shareholders. For example, £1 million in from selling off assets is less sustainable than £1 million from recurring sales, and if firms don’t communicate its sources of profits, or its ability to make them recur, investors may misjudge the value.
4. Prospects: The focus of profit maximisation is short-term, but shareholders only care about the future growth, for example, Amazon when it was in its early years – little profits but huge growth opportunities. Profit maximisation ignores the growth prospects entirely.
5. Risk: Profit maximisation does not take into account the risk element of earnings, for example, £1 million profit from a risky project is not the same as from a low-risk and stable operation. Shareholder wealth makes an adjustment in this regard – known as “risk-return trade-off”, whereas profit does not.
6. Additional Capital: A firm can increase profits by raising more capital and scaling up, but this does not guarantee that existing shareholders are better off as a result. What matter to shareholders is ROE/ROCE, not absolute profit. Profit maximisation ignores whether returns justify the risk and cost of capital required.

The thing to consider is that not all shareholders are the same, we do have some that are more focused towards stability, and predictability – some being more focused on the business side, than the financial side. Here are a few to consider;

1. Remuneration (Income Focused): Some shareholders prefer a regular attractive dividend that they can depend on, not just analysing the market to sell higher than what they bought (making a gain). For example, retirees or pension funds. This option is the opposite to growth investors because it can reduce reinvestment (less demand).
2. Empire Building (Expansion Focused): Some shareholders prefer to focus on the size of the company, like it’s assets, influence, and reach, not just the profitability it can achieve – which can further the future the investment they make in the firm. Expansion may lower immediate returns and increase risk and can conflict with income focused or risk-adverse shareholders.
3. Employees (Harmony Focused): Some shareholders are focused on maintaining the flow of the firms' activities, by ensuring there is harmony with employees – like prioritising the avoidance of strikes, agitation, or mass redundancies. This can lead to reduced profits and increased expenses to support bonuses, further incentives, etc.
4. Survival Focused: Some shareholders value stability and continuity within the firm, which can result in less returns for other shareholders. This can sometimes mean cutting dividends, avoiding risky investments, and more a focus on liquidity – which goes against growth-focused investors.
5. Quality Focus: Some shareholders focus on the prioritising of product/service quality (normal business activities), even if it results in less profit margins. This can affect the shareholders focused on the short-term, but for long-term shareholders, it can assist in the brand value and market share of the firm.
6. CSR/ESG Objectives: Some shareholders focus on the sustainability, reputation and ethical practices that the firm has, which can result in higher costs and ultimately lowering profits, but it can protect the long-term value by lowering regulatory risk, reputation, and customer loyalty.
7. Lower Risk Preference: Some shareholders focus on stability, and predictable returns, even if they are lower as a result of taking on less risk. This can cause a clash with growth focused shareholders who want to take on the risk-reward projects.
8. Market Share Maximisation: Some shareholders focus on market domination, usually by cutting prices and aggressively reinvesting. This can reduce short-term profits and dividends, but it increases the long-term value, especially if market dominance is achieved.

The differences in Shareholder priority means that not everyone will be in agreeance on what wealth maximisation would look like. Too much of a focus on a sole preference could reduce the value for the others – for example;

1. High dividends now mean less reinvestments for future growth.
2. A focus on growth means lower short-term payouts.
3. CSR focus means lower profits for the short-term, but better long-term survival.

This is exactly where the agency problem and corporate governance jump in, as in, managers (or Agents) try to balance the potentially multiple shareholder objectives and priorities while making sure there is long-term value.

Agency Relationships

When you appoint another person to do something on your behalf, you create what is known as an “Agent”. An agent is employed by a “Principal” to carry out a task on their behalf. This would be something like a shareholder appointing a director, or management.

There is something known as “Agency Theory”, which looks are the implications of both the principle and agent relationship. For one, there is “Divorce of Ownership and Control” in which control of the firm is, and its direction is upon management, but ownership of the firm remains with the shareholders. This relationship is not always a stable one, it can have its “rocky” moments, or conflicts – these can happen when the objectives of the two parties are not one in the same, for example, shareholder may want to dominate the market they are in, whereas management want to focus on stability within the firm. There are ways in which the conflicts can be mitigated, however, it does come with a cost, and regardless of the effort or amounts dedicated to the mitigation, it cannot be eliminated, nor reduced to zero.

Taking a closer look, what could cause a conflict within the relationship? As mentioned, managers may focus on their own objectives and these can vary, here are some;

1. Remunerations: Managers focused on remunerations, such as salaries, pension contributions, benefits-in-kind, are increased costs for the firm. This reduces both the distribution of profits for dividends and retained earnings available for reinvestment. This means that growth-focused investors (who are after capital gains) are affected because the market can assume there are less funds for future growth (expansion, R&D etc), which can reduce the share price, affecting shareholders ability to generate capital gains. This also affects income-focused shareholders (who are after dividend payouts) because increased costs mean less profits to distribute for meeting dividends. Additionally, CRS-focused shareholders (who promote ethical practice) may view remunerations as unjustified and misaligned with shareholder interests, potentially damaging the firm’s reputation and long-term value.
2. Job Satisfaction: Managers focused on personal satisfaction within their role in the firm could lead them to prioritising projects that bring lifestyle perks, activities, or personal exposure – rather than those that maximise returns. This results in the firm being pulled away from shareholder objectives, causing issues. Ultimately, we find ourselves in the same issue as remunerations. For growth-focused shareholders, this can mean the market viewing the firm as incapable of making appropriate decisions, reducing the share price – leading to a reduction in their ability to generate capital gains. For income-focused shareholders, this can mean less profits for distribution to meet dividend payouts.
3. Job Security: Managers focused on job security are likely to avoid projects that require risk because failure could threaten their position within the firm. This could look like under-investments, safe projects offering mediocre returns, and holding excessing cash reserves “just in case”. For both growth and income focused shareholders, this means less capital gains and dividends because of less profit and the market viewing the firm as lacking ambition or being undermined by competition – dropping the share price value.
4. Maximisation of Firm Value: Maximising the firm’s value might appear strange, especially because this is what we want (and encourage). However, the agency problem is the disconnect between the reasons for maximising. Management is short-term focused – they want recognition for their hard work, they want to be achieving unbelievable profits, and pursing projects that elevate status. Whereas shareholders and long-term focused wanting to ensure future value within the firm – they would rather the value be maximised in a way that promotes discipline, planning and sustainability in the long-term. In other words, shareholders don’t want it all at once now, they want to ensure the firm has a future.

In conclusion, the results of potential agency problems threaten the future of the firm, but it also affects the TSR for shareholders. These issues come down to a less profit for distribution to cover dividend payouts, and the markets perception of the firm prospects, as well as their ability to generate returns that would warrant purchasing shares. The reasons for these ultimately come down to the differences in objectives between management and shareholders. Therefore, we see a loss in actual cash flow, and opportunity cost.

Now that we’ve highlighted the agency problems, how do we mitigate them? There is an agency monitoring mechanism we use that mitigate both internal and external ways in which shareholders use to keep managers aligned with their objectives.

Internal Mechanisms are done from within the firm, usually set up by directors or board to directly influence management. Some of these include;

1. The Board of Directors: They monitor the performance of management, like their decisions and strategies they use. Independent directors reduce the risk of collusion with management by challenging things like investment decisions, capital allocation, financial reporting etc. This ensures that management are held accountable to shareholders as opposed to pursuing they own personal agendas.
2. Pay Incentives: As opposed to straight oversight and reporting, there is also incentives that can be used. Typically, we may find pay of executives being linked to performance metrics, like TSR, EPS, ROE, or ROI. Meaning that levels of pay are based upon satisfying the interests of each shareholder type. However, care structure is needed here because these are typically designed and reported on by the CFO.
3. Internal Audits: These check processes, spending, and reporting to ensure compliance with relevant accounting standards, which encourages executives to ensure accurate financial reporting, preventing manipulation of accounts or misstatements of profits, etc. Internal audits also affect strategic decisions – which are reported to the board/shareholders.
4. Ownership Structure: At times, the structure of ownership in the firm can also influence executive behaviours. For example, having large shareholders, like institutional investors – they can monitor and intervene should they need to. This applies pressure to the executive because losing/upsetting them, means risking their position and all that come with it.
5. Career Incentives: Can be used to influence the performance of executives by offering promotions, career progression, benefits, etc. This means that for executives that have poor performance may find themselves with less opportunities within the firm, and/or less pay incentives.

External mechanisms are done outside of the firm, usually by the market, and regulations. Some of these include:

1. Takeover:
2. The Market:
3. Competition:
4. Regulations/Laws:
5. External Audits:
6. Career Incentives:

Should management still find themselves still pursuing personal agendas, the question is raised, can management be replaced if they do not perform? Theoretically, yes. Shareholders appoint directors who employ managers which they can hire and fire via the AGM (Annual General Meeting). However, in practice, this can be a bit more complex. There is, in reality, only two ways in which management can be replaced, those are direct and indirect.

1. Direct: As mentioned, shareholders appoint directors (The Board), which have the power to hire and fire management at the AGM (not shareholders). They can do this simply with it being a power of theirs. If management are also executive directors, shareholders can vote them out of being a director – which they can lose their management role too.
2. Indirect: Shareholders either don’t, or cannot remove management, so instead they sell their shares, reducing both share price and demand. This can trigger a takeover by new shareholders (owners). The new owners appoint a new board, and the new board replace management. This is done when shareholders decide to walk away and give up their ownership of the firm.

Stock Market Efficiency & Efficient Markets Hypothesis

There are different types of stock market efficiencies, for example, operational efficiency, where we focus on cost, speed, and reliability of transactions, with the focus of creating as much competition between participants in a market. We also have allocational efficiency, where we focus on the allocation of societies resources between investments, with the focus of providing funds for growth industries with only a small amount to slow or low growth industries. We also have pricing efficiency, where we focus on a risk-adjusted return for investors.

Pricing efficiency is of particular interest to us while we have the aim of shareholder wealth maximisation. Therefore, it’s important that the stock market fairly values shares in the market, allowing the share price to be rapidly and proportionally reflected by the addition of all new relevant information, giving insight into their economic value. This is what is known as “Efficient Market Hypothesis.

We know all too well that at times the market can become overwhelmed by both positive and negative opinions where news drops and the market panics thinking they need to buy shares, and they prop up the share price higher than the news implies, or the opposite where they sell shares anticipating a crash, or anything even remotely negative. Therefore, there are ways that investors can identify under or over valued shares to make abnormal returns.

Technical analysis is the forefront of the market, i.e., chartists, where they study charts of past share price movements to determine future movement. We have fundamental analysis, where we determine this via underlying factors such as sales, costs, competition, opportunity risks, etc. And we also have insider information, which is illegal, but is information available to a select few that that market is not aware of, this is the king of information, but also highly illegal because it prevents fairness within the exchange markets.

To have an efficient market, we need to have many knowledgeable investors active in analysing, and trading stocks. Information to be made widely available. Investors reacting quickly to information made available. And the consensus of price being reached. Consensus of price being when the price of a share, etc, is within the range that all investors, etc, agree on what the price should be.

In a market such as the ne described, under or over valued securities would not exist. Securities are, as mentioned, usually in equilibrium and are fairly priced where returns are relative to their risks resulting in no abnormal returns. Meaning the only way investors can obtain abnormal returns is by luck, better access to information, or new ways of interpreting the market that no other has figured out.

It's worth noting that even with an efficient stock market, the share price is not equal to that of the economic value at any point in time, and the deviations from it are random with share price being unbiased based on, as mentioned, available information, investor sentiment, objectives, etc.

In the market we have three forms of efficiency: weak, semi-strong, and strong. Weak is where the share price is reflected based on historical movements of the share price. Semi-strong is where it is reflected based on historical movements, as well as publicly disclosed information about the firms they are reviewing. Strong is where it is reflected in both, as well as information not publicly disclosed, usually indicative of the “true” value of securities.

Efficient market hypothesis – does it work? As much as we’d love to say yes based on what we’ve discussed, there are multiple Market Anomalies: Size effects: smaller firms yield higher returns than those of larger companies of comparable risk. Timing effects: seasonal effects, day of the week/time of day. Markets under reaction to announcements: earnings announcements, share repurchase, changes to dividend policy. Key indicators of undervalued shares: low share price relative to earnings – low p/e, low share price relative to balance sheet assets, high dividends relative to share price.