Externalities and Corporate Value: seeing beyond short-term profit

On Sept 13, 2020, the 50th anniversary after Milton Friedman wrote his seminal work “The social responsibility of business is to increase profits,” I have been reflecting on this passage: 

“In a free‐enterprise, private‐property system, a corporate executive is an employee of the owners of the business. He has direct responsibility to his employers. That responsibility is to conduct the business in accordance with their desires, which generally will be to make as much money as possible while conforming to the basic rules of the society, both those embodied in law and those embodied in ethical custom.”

This perspective can be true, yet tragically myopic and incomplete. The way this essay has been interpreted for 50 years does not go far enough into its own implied conclusions about what is to be done and who is responsible for doing it. 

What this passage implies is that the owners of the business have a responsibility first and foremost to act in accordance with the actions that will increase the long-term value of the business. These owners, shareholders and the Board of Directors, must first understand that the markets reward future returns, not past returns. The stock market is fundamentally a market that works to predict future returns to the business, and the Board’s role is to ensure the long-term survival and success of the enterprise in the future. This fundamental insight has been lost in business decision making, as the processes for looking at value and risk have been hijacked by backward-looking conversations and mechanisms for prediction that are limited to the short term -- a few quarters at best. 

The business executive who maximizes short-term profit without understanding how their actions will affect the long-term profitability and success of the business is short-sighted and is sucked back into working against the actual business interest. Thus, the investors and Board of Directors must keep the business executive focused on long-term value and the survival of the business. This is their primary function and responsibility. 

What are some of the aspects that result in long-term value and survival of the business which need to be forefront on the minds of investors and corporate boards?

1. Long-term sustainability of the resources required to produce its products. This means that the resources that are inputs into the business’ products must be sustained at an adequate level so as to ensure that the cost of these resources will not increase due to diminishing supply. This would mean, for example, that the investors in logging companies would account for the increasing or decreasing supply of trees in the world when analyzing whether the business is likely to increase or decrease profits in the long term. At the extreme, any business that is likely to deplete through its actions an element of its supply resources should be valued close to zero.  
2. Growth of the company’s customer base and total addressable market (TAM). Without a growing customer base, a company’s future growth potential will be limited. For example, for most consumer products, it is imperative that the consumer population does not become destitute, as this would mean that in the future, the TAM for the product will shrink as a growing proportion of people will not have enough money to purchase its products. This would imply that Boards and investors would hold accountable consumer companies for maintaining a reasonable standard of income for the general population, at minimum to support future purchases of its products. 
3. Maintenance and support of the institutions that allow the company to produce, distribute, and exchange efficiently. Numerous economic studies have shown that institutions which create trust in the economic system reduce transaction costs. The reduction of transaction costs then produces economic efficiencies in the aggregate, benefitting all the enterprises in the system. That benefit, in the long term, vastly outweighs the benefits of short-term undermining of aspects of our institutions that might give a short-term benefit to any specific company. What this would mean, for example, is that a social media company that does not work to prevent the undermining of democratic institutions would be devalued, no matter how many lobbyists it has working to sway legislation to its benefit in the short term. This is because, historically, societies that move away from transparent democratic rule have a high probability of authoritarian governments overtaking the means of communication distribution. By allowing democracies to be undermined, social media companies are acting against their own long-term economic interests. 

This analysis concludes that investors, through corporate governance and Boards of Directors, must look beyond short-term analysis of value and risk and toward an approach that factors in the long-term value of the enterprise based in the impact its actions are making on the sustainability of its future resource supply, the economic well being of its future customers, and the maintenance of the institutions that increase economy-wide trust -- all for their own long-term success. 

In mainstream economic theory, pricing these factors into the value of a corporation would be akin to pricing in externalities. By pricing externalities into corporate value, we can not only prevent corporations from making more moves that will destroy their own long-term value, but we can also incentivize the creation of positive externalities that would increase the company’s long-term value. For example, an enterprise tech company that invests in creating an educational resource to help people learn tech skills, can add to its future customer base by increasing the availability of skilled workers to work with its products as well grow the middle class that will increase demand for its customers’ products. This company should be rewarded a positive externality premium by investing in the future customer base, since it has also increased the chances of the company’s success in the future by growing future demand. 

The problem with our approach to corporate value has come, in part, from a lopsided interrogation of Milton Friedman’s work. He wrote: “The whole justification for permitting the corporate executive to be selected by the stockholders is that the executive is an agent serving the interests of his principal.” Therefore it is the responsibility of the principals to ensure the long-term survival and success of the company, through the way the stock market values corporations and the way Boards of Directors develop their controls over corporate governance. Friedman acknowledges that social responsibility by corporations is economically justified when it is the “by‐product of expenditures that are entirely justified in its own self‐interest.” Here I have proposed that by properly pricing in positive and negative externalities produced as a by-product of corporate actions, we can align around the long-term value of corporations more accurately, and end this silly debate (as well as the ultimate potential destruction of economy-wide value when actors optimize for short-term profits instead of long-term enterprise survival and economic value) once and for all. 

Opinions here are entirely my own