Shareholder wealth is defined by the market value (the price the stock is trading for on the stock market) of the shareholders’ common stock holdings. Total shareholder wealth is the number of shares outstanding multiplied by the market price per share. Thus, the market values of the shareholders’ common stock holdings measure the shareholders’ wealth. The formula used for determining shareholder wealth is “Shareholder wealth = Number of shares outstanding x Market price per share.” For example, if a corporation has 5 million shares of common stock trading on the market for $22 each (5,000,000 x $22), the total shareholders’ wealth is $110 million. The market value of common stock reflects the “magnitude, timing, and risk associated with the expected future benefits accruing to stockholders” (Moyer, McGuigan, & Rao, 2007, p. 2). Likewise, the market value of shares, reflect the amount, timing, and risk of future cash flows for the firm. Therefore, management should always strive to maximize shareholder wealth.

For this reason, it is important to understand the distinct differences between shareholder wealth and profit maximization. Shareholder wealth maximization is impersonal and provides a clear guide for decision-making and risk consideration. For example, greater cash flows result in higher stock prices while uncertain, high-risk, and distant cash flows result in lower stock prices. Furthermore, the market and not individuals within the company determine the stock prices. Therefore, the long-term goals of the firm remain the priority over the potential short-term goals of an individual. Conversely, profit maximization often does not provide a clear guide or timeline for decision-making, may lead to self-seeking decisions by managers in search of perquisites, and provides no direct way for financial managers to consider risks. Finally, there are far too many definitions for the term profit for anyone to define it clearly, and even if defined, it remains unclear whether a firm should maximize total profit or earnings per share. Obviously, for a firm to succeed, decision makers require impersonal, objective, and accurate information. Unlike managers whose primary goal is profit maximization, managers with a primary goal of shareholder wealth maximization have impersonal, objective, and accurate information available to make successful decisions for the long-term life of the company.

Though short-term goals are vital for maintaining a firm’s objectives, all short-term goals should be in place solely for achieving long-term sustainability and increased market value. Therefore, the goal of shareholder wealth maximization is a long-term goal achieved by a series of short-term decisions enacted for maintaining or exceeding expected shareholder wealth. Maximum shareholder wealth is not a short-term goal by itself because increases in current stock prices followed by dramatic decreases are too risky for shareholders and will result in lower market value. Managers that concentrate on short-term goals fail to consider the long-term impact of decisions. Conversely, managers with a primary goal of maximizing shareholder wealth consider both the short- and long-term impact of decisions and therefore increase the market value of the firm.

Nevertheless, some managers may still pursue goals other than shareholder wealth maximization. The personal goals of a manager, such as increasing company size, capturing a new target market, job security, or simply trying to reach a secondary goal of the firm in hopes of receiving additional compensation or perquisites may distract the manager from concentrating on the primary goal of shareholder wealth maximization. When the manager concentrates on achieving personal goals over shareholder wealth maximization, decisions made by the manager fail to consider the long-term effect the decisions will have on the market value of the firm. A primary component that leads to this type of principal-agent conflict is that managers usually hold a very small percentage of the shares while the shareholders hold a large percentage of the shares. The lower total of a manager’s shares, when compared to the higher total of shareholders’ shares tends to increase the potential for a manager to concentrate on short-term personal goals over the long-term goals of shareholders (Moyer, McGuigan, & Rao, 2007, p. 8). Fortunately, there are several mechanisms, such as managerial compensation, monitoring by the board of directors, and the threat of takeovers, that assist in reducing these types of principal-agent conflicts.

References:

Moyer, R.C., McGuigan, J.R., & Rao, R.P. (2007). Fundamentals of contemporary financial management (2nd ed.). Mason, OH: Thomson South-Western.

Moyer, R.C., McGuigan, J.R., & Rao, R.P. (2007). Study guide: Fundamentals of contemporary financial management (2nd ed.). Mason, OH: Thomson South-Western.