456 CHAPTER 12 Corporate Valuation, Value-Based Management, and Corporate Governance
Sometimes companies focus on their profitability and growth, without giving ade-
quate consideration to their capital requirements. This is a big mistake—all the wealth
creation drivers must be taken into account, not just growth. Fortunately for Bell’s in-
vestors, the revised plan was accepted. However, as this example illustrates, it is easy
for a company to mistakenly focus only on profitability and growth. They are impor-
tant, but so are the other value drivers—capital requirements and the weighted aver-
age cost of capital. Value-based management explicitly includes the effects of all the
value drivers because it uses the corporate valuation model, and they are all embodied
in the model.What are the four value drivers?
How is it possible that sales growth would decrease the value of a profitable
firm?Corporate Governance and Shareholder Wealth
Shareholders want companies to hire managers who are able and willing to take what-
ever legal and ethical actions they can to maximize stock prices. This obviously re-
quires managers with technical competence, but it also requires managers who are
willing to put forth the extra effort necessary to identify and implement value-adding
activities. However, managers are people, and people have both personal and corpo-
rate goals. Logically, therefore, managers can be expected to act in their own self-
interests, and if their self-interests are not aligned with those of stockholders, then
corporate value will not be maximized. Managers may spend too much time golfing,
lunching, surfing the net, and so forth, rather than focusing on corporate tasks, and
they may also use corporate resources on activities that benefit themselves rather than
shareholders. So, a key aspect of value-based management is to motivate executives
and other managers to actually take the actions required under value-based manage-
ment.
This section deals with corporate governance, which is defined as the set of rules
and procedures that ensure that managers do indeed employ the principles of value-
based management. The essence of corporate governance is to make sure that the key
shareholder objective—wealth maximization—is implemented. Most corporate gov-
ernance provisions come in two forms, sticks and carrots. The primary stick is the
threat of removal,either as a decision by the board of directors or as the result of a hos-
tile takeover. If a firm’s managers are maximizing the value of the resources entrusted
to them, they need not fear the loss of their jobs. On the other hand, if managers are
not maximizing value, they may well be removed, by their own boards of directors, by
dissident stockholders, or by other companies seeking to profit by installing a better
management team. The main carrot is compensation.If compensation is strictly in the
form of salary, then managers will have less incentive to focus on their firms’ values
than if compensation is somehow linked to their firms’ performance, especially stock
price performance. We discuss different types of motivational devices in the following
subsections.Provisions to Prevent Managerial Entrenchment
Suppose a company has a weak board of directors and strong anti-takeover provisions
in its corporate charter, causing senior managers to feel that there is little chance thatSee the web pages of
CalPERS (the California Pub-
lic Employees’ Retirement
System), http://www.
calpers.org,and TIAA-
CREF (Teachers Insurance
and Annuity Association-
College Retirement Equity
Fund), http://www.tiaa.org,
for excellent discussions of
shareholder-friendly corpo-
rate governance.