Finance and Wealth Maximization
The primary objective of profit-oriented businesses is to make as much money as possible, within certain constraints. Economists have long spoken of profit maximization as a guiding principle for profit-oriented businesses.
The field of finance, however, makes a distinction between profit maximization and wealth maximization. In general, the finance departments of profit-oriented organizations adhere to the principle of wealth maximization as a guiding force in financial decisions.
Why might profit maximization be an insufficient or improper goal for a business?
There are three main reasons why profit maximization is an inappropriate goal for businesses:
- A business can do things to maximize short-run profit that are clearly undesirable in terms of long-run profit, such as delay needed maintenance on its manufacturing plant and equipment or deplete its inventory of goods.
- A business must often make trade-offs between profits and risk.
- It is not clear how a firm should define profit. How can a business decide between profits now and in the future or between profit and risk?
The graph below plots the Total Return to Shareholders versus the Profitability (Return on Equity) for a given industry. The two dashed lines indicate the Industry Average values for each of the two axes:
- About 40% for Total Return to Shareholders
- About 25% Profitability
The quadrant that is shaded pink illustrates why profit is not always a good measure of a company’s wealth. Specifically, as the shaded area indicates, some companies achieve above-average profitability, but below-average shareholder returns.
Factors that Determine Value
Wealth is defined as the market value of the business. In partnerships and sole proprietorships, wealth is the price for which the owner(s) could sell the business. For corporations, wealth is the value of the firm to its owners (the shareholders). The factors that determine this value are:
Wealth and Per Share Value
The primary goal of the corporation is to maximize the value of the stock for shareholders. This statement assumes that in working to achieve this goal, the business or company will function in a legal and ethical manner (or risk ruining the company, as Enron executives did). Tactical activities —such as meeting quarterly numbers— and strategic goals —like being the biggest company in the industry— are only worthwhile if they increase the per share value of the corporation’s stock.
Financial managers use the per share value of the firm’s stock as a measure of wealth based on the assumption that the share price reflects investors’ assessment of current and future dividend payments and cash flows.
Maximizing the current value per share of existing stock takes into account the trade-offs between short-run and long-run profits, and between profit and risk — since these are reflected (at least in an efficient market) in the market value of the business.
Exercise: Difference Between Wealth and Profit Maximization
Below is an exercise demonstrating the importance and the difference between wealth maximization (shareholder return) and profit maximization. Read the paragraph below, then follow the instructions.
Consider the following data for two segments of the Energy industry:
- Energy Equipment and Service providers (like Halliburton, Transocean, Schlumberger)
- Oil & Gas Producers (like Exxon-Mobil, ConocoPhillips, and Chevron)
Two popular measures of performance are presented in the graphs below:
- The graph in Question #1 illustrates profitability (return on equity, or profits divided by shareholder equity)
- The graph in Question #2 illustrates shareholder return (total return to shareholders, or the amount the stock has appreciated plus any dividends paid by companies).
Consider the graphs and answer the following questions:
1. Based on what you see, which industry performed better? Why?
Based on the information illustrated in the graph, the Return on Equity (ROE) – a measure of profitability – for oil and gas producers was 11% higher than energy equipment & services. Therefore, based on this metric, oil and gas producers were more profitable than energy equipment & services.
2. Based on the Total Return to Shareholders information presented in this graph, which industry performed better? Why?
Energy equipment and service providers provided a 52% return to shareholders versus the 35% that oil and gas production generated. Therefore the energy and equipment industry performed better as it provided a 17% greater return to shareholders.
3. Which outcome is more desirable?
Ultimately the goal of every corporation is to maximize a shareholders’ wealth by maximizing the net value of the business, thereby generating the highest possible return. Therefore, as the energy equipment and service providers provided a higher return to their shareholders, this outcome is more desirable.
To test your understanding of the content presented
1. Which of the following should be the primary goal of the corporation?Choose only one answer below.
a. Maximize the value per share of its existing stock
Correct. The primary goal of the corporation is to maximize the value of the stock for shareholders. This assumes the business will function in a legal and ethical manner (or risk ruining the company, as Enron executives did). Tactical activities (like meeting quarterly numbers) and strategic goals (like being the biggest company in the industry) are only worthwhile if they increase the per share value of the corporation’s stock.
b. Maximize quarterly profit numbers
c. Have the largest revenue of any company in its industry
d. Enrich the communities within which it operates
2. Which of the following factors determine the market value of a business?
- Cash flows accumulating to the company
- Timing of cash flows
- Risk associated with the cash flows
Choose only one answer below.
b. I and III
c. II and III
d. I, II, and III
Correct. Cash flows accumulating to the company, timing of cash flows, and risk associated with the cash flows are all factors that determine the wealth of a company.
3. Economists deal in _______________, while stockholders are more concerned with ________________.Choose only one answer below.
a. wealth maximization / profit maximization
b. money / profit
c. profit maximization / wealth maximization
Correct. Economists deal in profit maximization, while stockholders are more concerned with wealth maximization.
d. shareholder returns / profit maximization