In 1958, Nobel Laureates Franco Modigliani and Merton Miller controversially claimed that, under certain assumptions, the value of a firm is independent of its capital structure.
Their article was a landmark at the time. Executives were fretting about how to fine-tune their capital structure, paying fat fees to bankers and consultants to advise them. Modigliani and Miller pointed out that they were wasting their time—CEOs should instead concentrate on the operational side of the business.
The key words, of course, are ‘under certain assumptions’. These assumptions, such as no taxes or bankruptcy costs, clearly don’t hold in the real world. Yet, even in 2020, the Modigliani-Miller theorem is a cornerstone of MBA finance classes around the world. The theorem is valuable not because capital structure is actually irrelevant, but because it highlights the only reasons why it can be relevant. A company should only base its capital structure on violations of the assumptions such as taxes and bankruptcy costs—and not other arguments such as ‘debt is cheap and equity is expensive’. Modigliani and Miller’s article was a landmark at the time; it remains a landmark today, and has been cited over 26,000 times.
In 1970, Nobel Laureate Milton Friedman controversially claimed that, under certain assumptions, a CEO should focus entirely on maximizing profit and not on serving society.
His article was a landmark at the time. But, unlike Modigliani-Miller, today it’s an object of scorn and ridicule. It’s been cited over 20,000 times, yet most of these citations are to highlight how broken shareholder capitalism is. 3,000 of those citations have come in the past year, as the stakeholder capitalism movement has gathered momentum. To declare that you reject the Friedman doctrine has become almost a requirement for acceptance into polite society.
But advocates of stakeholder capitalism, like me, can learn a lot from Milton Friedman by using his article in a similar way to Modigliani-Miller. Friedman highlighted the assumptions under which ‘the social responsibility of business is to increase its profits’. If—and only if— those assumptions are violated, is there a case for moving away from shareholder value.
The first step to learning from it is to understand what Friedman actually said. While this may seem a truism, Friedman’s article is widely misquoted and misunderstood. Indeed, thousands of people may have cited it without reading past the title. They think they don’t need to, because the title already makes his stance clear: companies should maximize profits by price-gouging customers, underpaying workers, and polluting the environment.
By presenting Friedman as a narrow-minded caricature, critics of capitalism can then push their own theory of how it should operate, and it’s not difficult to argue that theirs is superior when the alternative has been presented as a straw man.
But Friedman never advocated that companies exploit stakeholders. He argued that it is legitimate for a company to focus on increasing profits because the only way it can do so, at least in the long term, is if it treats stakeholders seriously. He wrote, ‘It may well be in the long-run interest of a corporation that is a major employer in a small community to devote resources to providing amenities to that community or to improving its government. That may make it easier to attract desirable employees’.
Thus, while last year’s Business Roundtable statement was heralded as ‘the end of Friedmanism’, it’s fully consistent with it. Any company maximizing shareholder value needs to ‘commit to delivering value to our customers … investing in our employees … dealing fairly and ethically with our suppliers … [and] supporting the communities in which we work’.
Indeed, critics of shareholder value attack it for being short-termist, but this makes no sense because shareholder value is an inherently long-term concept. Shareholder value is the present value of all future cash flows that a company generates. That’s not just abstract theory—it holds in practice. Some of the world’s most valuable companies are tech firms whose market valuations are orders of magnitude higher than what their short-term profits imply.
But there are at least three important assumptions in the Friedman doctrine. These assumptions don’t always hold in the real world, thus yielding a case for stakeholder capitalism. Yet just like Modigliani-Miller, Friedman is a useful starting point, because only if these assumptions are violated should we move away from explicit profit maximization.
'There are at least three important assumptions in the Friedman Doctrine. These Assumptions don't always hold in the real world, thus yielding a case for stakeholder capitalism.'
One key assumption Friedman makes is that a company has no comparative advantage in socially responsible actions. $1 spent on a social initiative creates the same value as $1 spent by anyone else. This assumption holds for many initiatives, such as donating to charity: A company could instead pay higher dividends to investors or wages to employees, or charge lower prices to customers, and they could donate it to the charity of their choice. So Friedman did recognize that individuals have social responsibilities beyond profits. He argued that the social responsibility of business is to increase profits because doing so gives individuals—investors, employees, and customers—maximum flexibility to choose which social responsibilities they wish to fulfill. It’s not the CEOs’ prerogative to take this decision away from them and support their own pet social cause.
This has profound implications, because many companies—and even governments—believe that stakeholder capitalism involves corporate philanthropy. India requires large companies to spend 2 percent of their profits on CSR initiatives; many firms around the world make similar pledges voluntarily. But if you’re a drinks company, your expertise is making drinks —not choosing which charitable causes are most worthy.
Friedman’s doctrine states that companies should only invest in social causes if they can generate more value than anyone else, and there are many activities that satisfy this ‘principle of comparative advantage’. Coca-Cola has developed expertise in logistics to distribute its drinks all over the world, including the onerous last mile to a rural village. So its Project Last Mile leverages this expertise to distribute medicines throughout several African countries. It delivers medicines, rather than books, as the former must be kept cool—and, as a drinks company, Coca-Cola has a particular comparative advantage in refrigerated transportation.
But others don’t. Companies donating money to Black Lives Matter in the light of George Floyd’s tragic death would have been wise to heed the Friedman doctrine. They should have instead invested their money in recruiting under-represented minorities at all levels, stamping out discrimination in their promotion and evaluation processes, and ensuring that their culture encourages a diversity of thinking—actions that only they can control, which means they have a comparative advantage in doing so.
A second key assumption in Friedman’s article is that governments are well-functioning. Friedman states an important caveat to his claim: ‘there is one and only one social responsibility of business … to increase its profits so long as it stays within the rules of the game’. [emphasis added]
The government sets the rules of the game: it has ‘the responsibility to impose taxes and determine expenditures for such “social” purposes as controlling pollution or training the hard-core unemployed’. Some voters want high minimum wages and carbon taxes; others don’t. Politicians set regulations at the level that best represents the aggregate preferences of the electorate—or else they can be voted out. In contrast, a CEO who pursues social causes ‘is in effect imposing taxes, on the one hand, and deciding how the tax proceeds shall be spent, on the other’. She may pursue her own preferences, not shareholders’ or society’s.
However, regulation is imperfect, and this is another reason why businesses should have a social responsibility. Regulation is most effective at addressing measurable issues such as wages and carbon emissions. However, it’s much harder to regulate qualitative issues such as providing employees with meaningful work and skill development. Thus, a company could go above and beyond in the working conditions it provides. But the Friedman principle remains useful because there are situations in which regulation is generally effective. If a firm wishes to pay above the minimum wage, even though market forces don’t dictate this, it needs to have good arguments for why the government has set it wrongly.
The third key assumption is the most important, and is the reason why I am an advocate for stakeholder capitalism. This assumption is often overlooked as it’s only implicit in Friedman’s article.
When he argues that profit-focused companies will invest in stakeholders, Friedman is assuming that they can calculate the impact that such investments have on profit. Calculation works for some investments: When contemplating a new factory, a CEO can forecast how many widgets it will produce and how much it can sell them for. Subtracting the cost gives her the Net Present Value (NPV)—the investment’s impact on shareholder value. While the real world is risky, NPV is able to handle risk. The CEO can do a ‘sensitivity analysis’, where she plugs in different assumptions, and see how the conclusion changes.
But the implicit assumption in Friedman is that there’s no uncertainty. A risky problem can be analyzed, if you have a rough idea of its parameters and can do a sensitivity analysis around them. With uncertainty, you have no idea what the parameters are.
Consider the deliberately simple decision of whether to provide colleagues with a free gym. The cost is easy to estimate but the benefits are not. Will the gym attract and retain workers, and what’s their value to the firm? How many lost days due to sickness will the gym prevent, and how much would they have cost the company? How many interactions between colleagues in different departments will the gym foster? These questions are almost impossible to answer. There’s not even a baseline around which to conduct a sensitivity analysis. So you can’t calculate the NPV of the gym, and without it, you can’t justify the gym under shareholder capitalism.
Arguing that ‘increasing profits’ will lead a company to invest in stakeholders is only true if profits can be forecast with some degree of accuracy. For particularly uncertain investments, they can’t. Thus, NPV would lead a company to forsake many investments in its employees, and also other stakeholders, ultimately destroying shareholder value. The mindset of maximizing profits may actually lead to companies failing to do so.
That’s where stakeholder capitalism comes in. A company with explicit stakeholder objectives makes investments for intrinsic reasons—to deliver value to such stakeholders—rather than to instrumentally increase profits. This leads it to make many investments that are ultimately profitable, but could not be justified by a financial calculation. A company might build a gym simply because it cares about employee health. By doing so, it will recruit, retain, and motivate great workers, likely increasing profits as a by-product, even if this increase couldn’t be quantified at the outset.
Importantly, this argument means that it may be in a company’s own interest to adopt social objectives. Such objectives aren’t simply worthy or fluffy, but good business sense—the guide to decision making in a world of uncertainty. For example, one of my own studies finds that companies that treat their workers well outperformed their peers by 2.3-3.8 percent per year over a 28-year period, or 89-184 percent compounded. However, it’s highly unlikely that CEOs could forecast that stock return uplift when deciding to invest in employee satisfaction.
Now, such social objectives can’t be unfettered or a free-for-all. If a company moves away from NPV, it needs alternative criteria to decide whether to take an investment. In a recent book, I propose three. One is the ‘principle of multiplication’, that $1 invested in a stakeholder must create more than $1 to that stakeholder. The second is the aforementioned ‘principle of comparative advantage’, that $1 creates more value than someone else could by investing in that stakeholder. The third is the ‘principle of materiality’, that the stakeholder(s) the activity benefits must be material to the enterprise.
My proposed criteria aren’t necessarily the last word. But any advocate of stakeholder capitalism can’t attack Friedman’s rule—of appraising projects based on shareholder value—without proposing an alternative.
Overall, just as capital structure is not irrelevant for firm value, I believe that a company’s explicit goal should not be to maximize profit. However, by highlighting the assumptions required for his claim to hold, Friedman shows us that a company should only depart from intentional profit maximization where these assumptions are violated: the company has a comparative advantage, there is regulatory failure, or instrumental decision making is difficult. This is true in some cases, but not others such as charitable donations.
Moreover, this framework is relevant not only for business leaders but also investors. Savers are piling into ESG funds, but many such funds are channeling this capital to companies that support social causes in a box-ticking manner, not questioning whether the Friedman assumptions hold. Rather than ridiculing the Friedman doctrine and proclaiming its death, advocates of responsible business and responsible investing can use it to guide us.
This post was previously published on ProMarket from the Stigler Center at the University of Chicago Booth School of Business and can be found here.
Alex Edmans is a Professor of Finance at London Business School and the author of ‘Grow the Pie: How Great Companies Deliver Both Purpose and Profit’.