Opinion: How great companies deliver both purpose and profit
15 Oct, 2020 18:57
source: Alex Edmans
Singularity Financial Hong Kong October 15, 2020 – How great companies deliver both purpose and profit
About this author: Alex Edmans (@aedmans) is Professor of Finance at London Business School and Academic Director of the Centre for Corporate Governance. He is also the author of “Grow the Pie: How Great Companies Deliver Both Purpose and Profit”. This post is based on his recently published book Grow the Pie.
Capitalism is in crisis. The consensus among politicians, citizens, and even executives themselves—on both sides of the political spectrum and throughout the world—is that business just isn’t working for ordinary people. It enriches the elites, playing scant attention to worker wages, customer welfare, or climate change.
Citizens, and the politicians that represent them, are fighting back. The precise reaction varies—Occupy movements, Brexit, electing populist leaders, restricting trade and immigration, and revolting against CEO pay. But the sentiment’s the same. “They” are benefiting at the expense of “us”.
In turn, companies were responding—or at least appearing to. Sustainability became the corporate buzzword of the day. It was the theme of this year’s World Economic Forum in Davos. Last August, the US Business Roundtable radically redefined its statement of the “purpose of a corporation” to include stakeholders, rather than just shareholders. BlackRock chief Larry Fink, in his annual letter to CEOs the last few Januarys, has stressed that their companies must serve wider society.
But it wasn’t clear whether these leaders genuinely meant what they said. Critics argue that Davos is more about appearing to do good than actually doing good. Skeptics speculate that the Business Roundtable made that statement to pre-empt anti-corporate regulation. Indeed, out of the 20 companies whose CEOs sit on the Business Roundtable board, not one has changed its corporate governance guidelines in the light of the new statement. Cynics claim that Fink’s letters are a response to accusations that index funds are excessively passive and don’t hold companies to account.
Why is it that some leaders may not mean what they say? Why do some citizens advocate heavy regulation and trampling on shareholder rights? Due to the pie-splitting mentality. This mentality sees the value that a company creates as a fixed pie. Any slice of the pie that goes to business reduces the slice enjoyed by society, so the best way to protect society is to straitjacket business so that it doesn’t make too much profit. On the other hand, any slice that goes to society reduces what goes to business, so a CEO’s job is to price-gouge customers or exploit workers. And if she practices sustainability, she should reduce it to eye-catching “Corporate Social Responsibility” initiatives, such as signing statements but not changing actual behavior.
But viewing the relationship between business and society as a fight between “them” and “us” is deeply flawed. In a recent book, “Grow the Pie: How Great Companies Deliver Both Purpose and Profit”, I advocate the pie-growing mentality, which stresses that the pie is not fixed. The implications are profound. For citizens, high profits need not result from value extraction, but successfully serving a social need. And profits don’t just go to nameless, faceless capitalists but pension funds investing on behalf of citizens—investors are not “them”; they are but “us”. For CEOs, the best way to increase profits is not to take from society but to create value for society—higher profits then arise as a by-product. A company may improve working conditions out of genuine concern for its employees, yet these employees become more motivated and productive. A company may develop a new drug to solve a public health crisis, without considering whether those affected are able to pay for it, yet end up successfully commercialising it.
But is the pie-growing mentality different from simple profit maximization? In 1970, Milton Friedman controversially claimed that “The Social Responsibility of Business is to Increase its Profits”. This article has been widely misquoted by business critics to highlight how exploitative capitalism is—that it should focus on profits and exploit everyone else to do so. Indeed, to declare that you reject the Friedman doctrine has become almost a requirement for acceptance into polite society.
But Friedman never advocated that companies exploit stakeholders. He argued that it is legitimate for a company to focus on increasing profits because the only way it can do so, at least in the long term, is if it treats stakeholders seriously. He wrote, “It may well be in the long-run interest of a corporation that is a major employer in a small community to devote resources to providing amenities to that community or to improving its government. That may make it easier to attract desirable employees.”
However, a key assumption of Friedman is that companies can calculate the impact that such investments have on profit. Calculation works for some investments: When contemplating a new factory, a CEO can forecast how many widgets it will produce and how much it can sell them for. Subtracting the cost gives her the Net Present Value (NPV)—the investment’s impact on shareholder value. While the real world is risky, NPV is able to handle risk. The CEO can do a “sensitivity analysis,” where she plugs in different assumptions, and sees how the conclusion changes.
But Friedman’s argument assumes that there’s no uncertainty (known to economists as “Knightian uncertainty”). Uncertainty is different from risk. A risky problem can be analyzed, if you have a rough idea of its parameters and can do a sensitivity analysis around them. With uncertainty, you have no idea what the parameters are.
Consider the deliberately simple decision of whether to provide colleagues with a free gym. The cost is easy to estimate but the benefits are not. Will the gym attract and retain workers, and what’s their value to the firm? How many lost days due to sickness will the gym prevent, and how much would they have cost the company? How many interactions between colleagues in different departments will the gym foster? These questions are almost impossible to answer. There’s not even a baseline around which to conduct a sensitivity analysis. So you can’t calculate the NPV of the gym, and without it, you can’t justify the gym under shareholder capitalism.
Arguing that “increasing profits” will lead a company to invest in stakeholders is only true if profits can be forecast with some degree of accuracy. For particularly uncertain investments, they can’t. Thus, NPV would lead a company to forsake many investments in its employees, and also other stakeholders, ultimately destroying shareholder value. The mindset of maximizing profits may actually lead to companies failing to do so.
That’s where the pie-growing mentality comes in. A company with this mentality makes investments for intrinsic reasons—to deliver value to stakeholders—rather than to instrumentally increase profits. This leads it to make many investments that are ultimately profitable, but could not be justified by a financial calculation. A company might build a gym simply because it cares about employee health. By doing so, it will recruit, retain, and motivate great workers, likely increasing profits as a by-product, even if this increase couldn’t be quantified at the outset.
Importantly, this argument means that it may be in a company’s own interest to adopt social objectives. Such objectives aren’t simply worthy or fluffy, but good business sense—a guide to decision making in a world of uncertainty. For example, one study finds that companies that treat their workers well outperformed their peers by 2.3-3.8 percent per year over a 28-year period, or 89-184 percent compounded. However, it’s highly unlikely that CEOs could forecast that stock return uplift when deciding to invest in employee satisfaction.
Now, such social objectives can’t be unfettered or a free-for-all. If a company moves away from NPV, it needs alternative criteria to decide whether to take an investment. The book proposes three. One is the “principle of multiplication”: $1 invested in a stakeholder must create more than $1 for that stakeholder. The second is the “principle of comparative advantage”: $1 creates more value than someone else could by investing in that stakeholder. Thus, charitable donations don’t satisfy the principle, because a company could instead pay out higher dividends to investors, who can then support their preferred charities. The third is the “principle of materiality,” according to which the benefits from a stakeholder’s activity must be material to the enterprise. This is backed up by research showing that companies that perform well on all stakeholder issues don’t actually beat the market—but those that outperform on material stakeholder issues, and show restraint on immaterial ones, do.
My proposed criteria aren’t necessarily the last word. But any critic of shareholder capitalism can’t attack Friedman’s rule, of appraising projects based on shareholder value, without proposing an alternative. Moreover, the principles address a valid concern of departing from explicit shareholder value maximization—that it will lead to CEOs being unaccountable. It’s actually difficult to hold CEOs accountable using NPV analyses, since outsiders can’t calculate the NPV of a major strategic decision—it’s hard to know what numbers to plug into the analysis. But you can evaluate whether it satisfies the principles.
The pie-growing mentality thus represents a new approach to business that occupies a middle ground between shareholder value maximization and stakeholder capitalism. It aims to create value for both business and society, rather than only “us” but not “them”—and recognizes the limitations of reducing every decision to a financial calculation but also the importance of having decision criteria and an accountability framework.
(This post is republished with permission from the Grow the Pie blog.)