There is no shortage of controversy and misinformation these days surrounding shareholder capitalism.

As a finance professor, I find that puzzling. We teach shareholder capitalism in Finance 101. Its central maxim is that the purpose of a business is to create wealth for its owners. It underlies many of the analytical tools developed in university finance courses. Yet, the controversy persists.

Shareholder capitalism as a distinct concept is often attributed to a famous 1970 New York Times Magazine article by the Nobel Prize-winning economist Milton Friedman, who wrote that the purpose of a business “is to increase its profits.” In fact, this was hardly a new idea. Two hundred years earlier, Adam Smith recognized that owners operate their businesses for their own benefit while in the process making others – employees, customers and suppliers – better off. I never thought any of this was controversial. Yet, shareholder capitalism is increasingly being attacked.

How did this come about? My own profession deserves some of the blame. University finance courses usually focus on analytical tools rather than big-picture questions. Among them:

• If the goal is to maximize shareholder wealth, how do business decisions affect other stakeholders, including employees, customers and suppliers?

• Many people are not shareholders of any corporation. How does shareholder capitalism impact them?

• What role does shareholder capitalism play in economic growth and raising living standards?

The typical finance course has little to say about such questions. This has created a void, which has been filled with mischaracterizations of shareholder capitalism. In the book The Case for Shareholder Capitalism: How the Pursuit of Profit Benefits All, I address these issues and paint a more accurate picture of shareholder capitalism and the various corporate social responsibility frameworks vying to replace it.

Shareholders and Stakeholders are Trading Partners, Not Competitors

Some critics interpret shareholder capitalism as a zero-sum game in which the shareholders gain at the expense of the other stakeholders. If this were true, shareholder capitalism would not be capitalism, which Adam Smith (among others) argued was characterized by mutually beneficial exchange. This is close to self-evident: trade needs to be mutually beneficial, or people will stop trading.

Consider your own exchanges. If you are like most people, you trade your labor with a business or some other institution in return for income and then use your income to trade with other businesses for goods and services. These trades are intended to make you better off – and if they don’t, you will move on to trades with some other source of income. Of course, this is a two-way street: you cannot expect businesses to keep trading with you unless the exchanges also make the businesses’ owners better off.

By the same token, if the goal is to maximize shareholder value, the firm must allow other stakeholders to become better off – there is no other way. Customers decide whether they want to buy a firm’s products. Employees decide whether they want to sell the firm their labor. Suppliers decide whether they want to sell the business their goods and services.
Each party only chooses to trade with the business if it expects to gain from the transaction.

These other parties’ freedom to choose helps steer the firm’s behavior. Thus, the firm must make products that its customers value. It must offer wages and work conditions that attract employees. It must buy products from suppliers at prices that allow suppliers to profit, too. It must pay taxes. It must comply with the rules and regulations placed on it by the government. All these things must be accomplished for a firm to profit and create wealth for its shareholders.

Yet, it is easy to find examples where critics suggest that shareholder wealth creation is somehow one-sided and does not reflect mutually beneficial exchange. Consider the following quotation from World Economic Forum founder Klaus Schwab, a vocal critic of shareholder capitalism:

I wrote a book on modern management describing what is today called the stakeholder concept. It recognized that the business of business was not simply serving shareholder interests, but everyone who has a stake in the “well-being” of the enterprise: employees, customers and society.

Similarly, in 2019 the Business Roundtable, an association of CEOs from some of America’s largest corporations, updated its Statement on the Purpose of a Corporation. It did so because “each version of that document issued since 1997 has stated that corporations exist principally to serve their shareholders,” and that “this language on corporate purpose does not accurately describe the ways in which we … endeavor every day to create value for all our stakeholders.”

The Business Roundtable companies collectively had $7 trillion in revenues in 2019. How did they achieve this without creating value for their customers? Why do 20 million people choose to work at Business Roundtable companies if they do not make their employees better off?

Shareholder Value is a Long-Term Concept

Some critics of shareholder capitalism claim that it encourages the pursuit of short-term profits at the expense of value-maximizing investments. This is plainly untrue. When we say that the goal of a business is to generate profits, we mean the time-discounted sum of all profits over the life of the business. In shareholder capitalism, the goal is to maximize shareholder value, which is a function of all the firm’s future profits – and, of course, short-term profits are typically only a small part of shareholder value. I am not stating anything novel here. Firms regularly make investments that both lower current profits and increase shareholder value.

Now consider how the European Commission, the executive branch of the European Union, understands this issue. In 2020, it commissioned Ernst & Young to study the alleged problem of corporate short-termism. EY’s report begins:

The focus of corporate decision-makers on short-term shareholder value maximization rather than on the long-term interests of the company reduces the long-term economic, environmental and social sustainability of European businesses.

There is only one shareholder value. It is maximized by investing in value-maximizing projects limited by willingness to bear risk and the cost of capital. A corporate manager does not have different strategies that vary with an investor’s expected holding period. It is the same whether an investor plans to hold the stock for one year or 20 years.

The EY report also focuses on a metric that is the ratio of payouts (dividends and share repurchases) to investment. In justifying this metric, the report offers this explanation:

The hypothesis underlining this approach is that companies decide to use their net income either to fund their shareholders, or to invest in future earnings. Therefore, the increasing payments to shareholders will decrease the available resources to invest, in R&D, human capital or other kinds of capital expenditures (CAPEX), thus jeopardizing future productivity growth.

This statement is highly misleading. Maximizing shareholder value requires the firm to invest in all value-creating projects. A corporate manager first decides if the firm has value-creating investments – that is, investments in which the risk-adjusted cost of capital is less than the expected benefits – available to it.
If not, then and only then should it return capital to shareholders via dividends or share repurchases.

Corporate Social Responsibility, ESG and Other Subjective Labels

Critics of shareholder capitalism want to replace it with what they say is a new type of
capitalism, where the pursuit of social responsibility is the goal, or at least a goal. So, who gets to decide what is socially responsible?

Governments set the rules under which firms operate. There are over one million federal regulatory restrictions in the United States. In shareholder capitalism, the firm creates shareholder wealth by engaging in mutually beneficial trading while adhering to laws and regulations of the government under which it operates. What role, then, does corporate social responsibility play? In democracies, government regulations ultimately come from elected officials. Where do the persons issuing corporate social responsibility edicts get their authority from?

Consider environmental issues. Businesses may create negative externalities, such as pollution. Businesses also create positive things for society – some internal, some not – such as wealth, goods, services and jobs. There is a tradeoff: we get fewer positives when we impose regulations limiting externalities. Social responsibility edicts typically encourage firms to produce fewer environmental externalities than regulations allow. If successful, the edicts become de facto regulations and we replace the tradeoff resulting from regulations with a new tradeoff based on social responsibility edicts.

One salient issue in this vein concerns carbon emissions. Several fund managers have decided to act as de facto regulators on this matter. They can do so because shareholders increasingly own firms indirectly through various types of investment funds. This means that fund managers do the bulk of corporate voting. Some fund managers, such as BlackRock, have used their voting power to pressure firms to pursue environmental and social causes. They have joined consortiums with the stated goal of eliminating carbon emissions by 2050. One such consortium is Climate Action 100+. Its members include more than 700 investors with $68 trillion in combined assets. It “engages” with 166 companies that are major emitters. Climate Action 100+ asks this of its members:

Investors must ensure the businesses they own have strategies that accelerate the transition to net-zero emissions by 2050 or sooner, and align with the goal of the Paris Agreement.

These consortiums exist to enforce a policy that their members favor over government policies that reflect voters’ preferences through representative democracy. The Paris Agreement is not a law or regulation binding on any American firm. Reducing CO2 emissions is costly and reflects a tradeoff between the costs of reducing emissions and the costs of global warming.

Elected officials have largely rejected the Paris Agreement’s tradeoff because the costs of aggressively curbing CO2 emissions are very high. Indeed, some believe these costs are much higher than the costs of global warming. If we are going to make a major regulatory decision that impacts everyone, such as quitting fossil fuels by 2050, it is better to do so via government regulation. Each citizen does not have an equal voice in corporate voting, as we do, at least in theory, in political voting.

The straw-person argument against capitalism is that it does not work as perfectly in the real world as in textbooks. Of course, nothing in the real world works as it does in simplified models of reality. Real-world choices require choosing among flawed alternatives. In shareholder capitalism, imperfect firms compete in imperfect markets regulated by an imperfect government.

The critics of shareholder capitalism want to introduce an additional imperfect mechanism, which consists of giving themselves an outsized role in how corporate resources are used and how society is regulated. This comes at the expense of not just shareholders but also of individual choice in the marketplace and of having democratically elected governments set the rules and regulations.