This is Part 2 of an article I published last week for Linked In and last month for website readers. I felt it was important to start this discussion as we are in a new round of some experts providing confusion around which group is more important for the for-profit firm: shareholders (or owners in the private for-profit firm), customers or employees? If you missed it the article can be found in the archives of this newspaper or at my website cited below.
In Part 2 I want to discuss how I unite my views of customers and employees to provide superior total shareholder return for the publicly traded for-profit firm or owner wealth for the private for-profit firm. As I state in Part 1, my view is shareholders and owners (hereafter just owners where appropriate) are the most important group, but this view is nuanced, as you will see.
Why do I think owners are the most important group for firms to focus on and for which goals should be set? It is simply that common equity shareholders and owners invest their money in the business but are the last group of “stakeholders” to get paid and they bear almost all of the risk. A firm’s bankers, other creditors, and the government in the form of taxes get paid before owners do. Employees also get paid before owners as their monthly base compensation and benefits must be paid. Now owners can get dividends but these are not guaranteed and must be approved by the board after all the other stakeholders are paid. And owners have a long time horizon as it takes time to grow the value of their firms (stock price for the publicly traded firm) and thus their wealth. But there is no guarantee this will happen either. They bear all of the risk here. Why would this group not be the most important?
Ah what about customers you say? Customers are the lifeblood of any for-profit business and are crucial for short, mid and long-term success. But they can be extremely fickle and can defect to a competitor at moment’s notice. Very little binds a customer to your firm, unless you have built up what strategists call “switching costs”. IBM used this tactic for twenty years to their advantage. If you bought an IBM mainframe computer, you had to use only their card readers, peripherals, and other products. And when you choose a brokerage firm to invest your money, they make it difficult for you to switch to a competitor. When we buy a car we are normally locked in for a while, as many times the value of our autos will fall lower than the loan amount outstanding. But for most products and services, customers are free to leave your firm at their will.
This is true for employees as well. They can leave for a competitor unless you have a binding non-compete agreement or more positively providing such a good environment for their personal growth that they do not want to leave. But the courts have ruled that you cannot deny an employee a living and non-compete agreements are very difficult to enforce.
Shareholders and owners are the only long-term force in a business. But customers and employees are critical as well. How can we reconcile these issues and integrate the three groups of “stakeholders” for the benefit of all and I would say society as well?
Seven Key Drivers of Shareholder’s Return
There are seven key pure financial drivers of total shareholder return or owner wealth. I show the direction of each number to contribute to increasing shareholder value or owner wealth:
- Revenue growth (increasing)
- Operating profit margin (increasing)
- Taxes (decreasing where legal and in today’s world “ethical”)
- Incremental working capital investment to drive new rounds of revenue growth (decreasing)
- Incremental fixed capital investment to drive new rounds of revenue growth (decreasing). The reason for the direction in #s 4 and 5 is you want your capital to be highly productive in driving increases in revenue.
- Cost of capital (decreasing)
- Competitive Advantage Period (increasing) – this is the length of time into the future favorable directions in the first six drivers are expected to remain favorable
Managing these seven drivers for superior customer value as we defined it in the last article almost always destroys financial value in the short to mid-term. Firms must take on more expenses and invest more working and fixed capital to supply Benefits that are greater than the total Burden for customers to receive the Benefits. And sometimes firms must drop prices to contribute to customer value. More expenses and dropping prices decrease Operating Profit. More investment can be costly. All of this decreases financial value in the short to mid-term. Why would a firm do this? The bet is over the longer term you create a large enough group of customers who are willing to pay the price points that are large enough to produce free cash flow that is greater than the weighted average cost of capital. Done well over many cycles, we also produce high customer satisfaction and loyalty.
And here is almost a law of the workplace: when we have Engaged Our People Appropriately and Effectively, we produce a motivated work force that loves being Productive. In my view, willing Employee Productivity is the glue that ties all three stakeholders -Shareholders/Owners, Customers and Employees together. I am a former military officer and use USAA as my insurance company. For the most part USAA’s employees love working there as USAA has provided valued training and development, fair compensation and promotion opportunities combined with a culture that inspires pride and authentic motivation. They want to perform for USAA and themselves – they do not feel they “have” to.
People Productivity can be measured simply as Revenue divided by total Compensation Costs. Highly Productive people generate more revenue per person than their competitors do. Providing Superior Customer Value is a strategy, leadership and execution set of skills. Highly Productive People are seen as appreciating assets, not expenses and are the vehicle to deliver the Superior Customer Value. The result? Year over year increases in total shareholder return or owner wealth. And this virtuous cycle only entices owners to invest more of their money in expectation for further growth in wealth.
So to conclude, I think shareholders or owners are the group around which long-term goals should be set. Customers and employees are the beneficiaries as is society in the form of valued products and services that are offered and delivered and people who have long term livelihoods. How can we see this any differently?
This article is part of a series on what causes a firm’s value to increase
Bill Bigler is founder of Bill Bigler Associates and can be reached at firstname.lastname@example.org or www.billbigler.com.