1.9 The Goal of the Firm

Here, we will discuss the main objective or goal of most companies. In the past few sections, we have covered topics related to how stock prices are determined by supply and demand in financial markets and how new information can affect the demand for stocks and subsequently change stock prices. It is easy to think of cases about how management decision-making will lead to new information. Think about cases when a firm releases a new product or announces the acquisition of another competing company. These decisions will undoubtedly affect the stock price of the firm. The goal of the firm is, therefore, to maximize shareholder value. This is usually accomplished by profitable decision-making by management, investing capital into projects that will increase the firm’s stock price, and avoiding those investments that cost more money than they bring in.

Maximizing shareholder value might mean different things to different companies, depending on the type of company. A privately held company (a company with shares that are not available to the public) may define value differently than a publicly held company (a company with shares that are available to the public). Take, for instance, a private company that is made up of a few owners from a particular family. Privately held family businesses likely place more value on keeping the business in the family and will make decisions with that in mind. For publicly traded companies, the most reasonable and reliable signal of whether management is indeed maximizing shareholder value is by looking at the firm’s share price. In cases where management does not use the company’s resources in a way that maximizes shareholder value, the price of the company’s stock will decrease in an efficient market.

In the next section, we will discuss a few issues with the goal of companies being to maximize profit or maximize shareholder value.