Long-term business value in small companies

Serving the market or society? Can you do both?

It’s pretty safe to say that the economy today is caught up on delivering on short-term goals. This phenomenon is known as short-termism. Short-termism is usually focused around the earnings per share (EPS) ratio. One reason behind this phenomena is the fact that most shareholders today are not individuals, but rather institutions. Even though individuals are still active, they aren’t organized and they usually remain passive. The power instead lies with pension, hedge and mutual funds, giving them almost all of the influence and power. Having a diverse set of financial players generally means that there’s healthy competition and is therefore, usually, a strength of a capital market. But when the most frequent question that managers ask is if an acquisition will dilute EPS over the first couple of years – there’s a problem.

Performance against short-term measures

By always focusing on short-term EPS, many companies pass up the opportunity to create value. It has been shown that discretionary spending is reduced on areas like marketing, R&D and human capital in favor of meeting short-term financial goals. Managers are often inclined to give discounts to boost sales activation this quarter, as opposed to next. As most of the power lies with different fund managers, the goal will ultimately be short-term gains. With that focus, these investors are unlikely to show an interest in building the company’s policies or tackling issues regarding environmental and social risks. This approach, in the end, actually shortchanges all stakeholders. The result is a situation where companies are being discouraged from developing sustainable products and policies that would benefit society.

“Easy” doesn’t always cut it

The publication McKinsey Quarterly stated that there is no empirical evidence linking increased EPS with the value created by a transaction. So, even though many experts, bankers and investors vividly agree that short-term EPS results are not important in regards to value, it is still a common yardstick when evaluating a company. Why? The answer seems to be: because it’s easy. Everyone understands the concept of EPS so it simplifies trying to proving a point in the board room meeting or in various reports. Pressure for short-term results seem to especially arise when a company is in a more mature stage and preferably when companies grow by acquisitions. Investors are always on the look-out for high-growth companies, which is where the clash occurs.

Moving on from catch 22

So, what can be done about this catch 22? Suggestions on leverage points could be market incentives and transparency. A market incentive would be to encourage more patient, long-term capital through taxes that discourage exaggerated trading or introducing a minimum share-holding period. Internally, boards need to encourage managers who make smart decisions about trade-offs between short-term earnings and long-term value creation. This is not to say that short-termism isn’t sometimes effective, and that value creating actions sometimes do take a lot of time. They are not created equal, and shouldn’t always be held against each other. A balance between the two will lead to a healthier, more stable organization. Ultimately, a company should serve society in order to create value. The shareholders will benefit from this mindset, just maybe not right away. Valuing long-term value is the way to go!