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Why do business executives need to understand corporate finance now more than ever?

Posted on: 08/05/2019 | Written by: Professor Gabriel Hawawini , Cengage author and emeritus professor of finance at INSEAD

 

We often hear that managers should manage their firm’s resources with the ultimate objective of creating value. But value for whom? For the firm’s owners in the form of higher share prices? For the firm’s employees in the form of a motivated and well compensated workforce? For the firm’s customers in the form of higher quality goods and services offered at competitive prices? For the firm’s suppliers in the form of mutually beneficial relationships and long-term commitment? For the communities in which the firm operates in the form of investments that improve the lives of those who reside in these communities?

A strict interpretation of the value-creation principle would suggest that financial managers should focus on the share-price objective. After all, one could argue that finance is all about maximizing the firm’s market value and hence the wealth of the firm’s owners. This objective makes business common sense if you think about a firm whose recent management decisions reduced the firm’s value. What would happen if this value-reduction persisted? The firm would be unable to attract the funds it needs to sustain its activities. And without outside funds, no firm would survive for long.

But you may rightly ask whether we’re forgetting the contributions of employees, customers, and suppliers to the firm’s financial success. There is no doubt that no firm can succeed without their contributions. Successful companies not only have satisfied owners, but also loyal customers, motivated employees, and reliable suppliers. Our message is that the role and contribution of finance to the firm’s success is much broader than the achievement of a narrower financial objective.

Modern financial management is not an exercise in cost control, short-term profit-making and share-price boosting. It requires a holistic approach to value creation across all the firm’s stakeholders. And given the seismic challenges facing today’s business executives including environmental issues, equality and diversity in the workplace, and distrust in capitalism and business — particularly from the younger generation of workers — I would argue that business executives need to understand corporate finance now more than ever.

No firm has achieved a sustained rise in its market value by neglecting its customers, squeezing its suppliers, and ignoring the interests of its employees in order to deliver short-term benefits to its owners. In other words, a firm’s higher market value does not mean less value for employees, customers, or suppliers. On the contrary, firms managed with a focus on creating value for those who fund it know how to build valuable and durable relationships with their customers, employees, and suppliers. They know that dealing successfully with all the firm’s stakeholders is a key element to achieving their ultimate objective of creating value for their owners.

Professor Gabriel Hawawini

Indeed, evidence supports the fact that firms that take care of their customers and employees also deliver value to their owners. Consider the results of an annual survey¹ that asked executives, outside directors and financial analysts to rate the ten largest companies in their industry according to the following criteria: (1) the ability to attract and retain talented people; (2) the quality of management; (3) the social responsibility to the community and the environment; (4) innovativeness; (5) the quality of products or services; (6) wise use of corporate assets; (7) financial soundness; (8) long-term investment value; and (9) the effectiveness in doing business globally. Guess what? The companies with the highest scores across all industries significantly outperformed the Standard & Poor’s market index (a stock market average of the share prices of 500 companies) during the ten-year period that preceded the ranking. What was the stock market performance of the companies with the lowest scores? They were value destroyers. They delivered a negative return to their owners during the ten-year period that preceded the ranking. An analysis based on only the three criteria that relate to the way companies treat their employees (the first criterion), their community and the environment (the third criterion) and their customers (the fifth criterion) showed similar results.

These results clearly indicate that the ability of firms to create value for their owners is related to the way they treat their customers, their employees, and their community. But you should not conclude that the guaranteed recipe for value creation consists of delighting customers, establishing durable relations with suppliers, and motivating employees. Some firms that deal successfully with their stakeholders are unable to translate this goodwill into a higher firm value. What should the firm’s financial managers do in this case? They must revise the firm’s current business strategy because their owners will eventually question the relevance of a strategy that does not allow the firm to produce a satisfactory return on the funds they have invested in it. Dissatisfied owners, particularly those holding a significant portion of the firm’s capital, may try to force the firm’s management to change course or may try to oust the existing management team. Or, they may simply withdraw their support by selling their holdings to others who might force changes. That’s why business executives need to understand corporate finance now more than ever.

 

¹FORTUNE World’s Most Admired Companies 2019

 

Gabriel Hawawini is emeritus professor of finance at INSEAD where he served as dean and held the Henry Grunfeld Chair in Investment Banking.

The sixth edition of Finance for Executives: Managing for Value Creation by Gabriel Hawawini and Claude Viallet was published by Cengage on 26 March 2019.

 

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