- CFA Exams
- June 2019 Level II > Study Session 8. Corporate Finance: Financing and Control Issues > Reading 23. Corporate Performance, Governance, and Business Ethics
- 1. Stakeholders and Corporate Performance
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Subject 1. Stakeholders and Corporate Performance
- Internal stakeholders include stockholders and employees at all levels.
- External stakeholders are all other groups, and typically include customers, suppliers, creditors, governments at all levels, unions, local communities, and the general public.
Stakeholders are in a reciprocal relationship with the firm, providing the organization with resources and expecting some benefit in return. Each stakeholder group has a unique relationship with the firm.
- Stockholders provide funds and expect returns.
- Creditors provide funds and expect repayment and interest.
- Employees provide labor, skills, and ideas, and expect income, job satisfaction and security, and good working conditions.
- Customers provide sales revenues and expect products that provide value for money.
- Suppliers provide inputs and expect revenues and dependable buyers.
- Governments provide regulation and expect companies to adhere to the rules.
- Unions provide productive employees and expect income and other benefits for their members.
- Local communities provide local infrastructure and expect companies to behave as responsible citizens.
- The general public provides national infrastructure and expects the company to improve their quality of life.
Companies that neglect to satisfy the needs of one or more important stakeholder groups will find that the stakeholders withdraw their support, damaging the firm. However, a company cannot fully satisfy all of its stakeholders at the same time. To understand stakeholder needs and to develop effective strategies for satisfying those needs, companies use stakeholder impact analysis.
- Identify stakeholders.
- Identify stakeholders' interests and concerns.
- As a result, identify what claims stakeholders are likely to make on the organization.
- Identify the stakeholders who are most important to the organization's perspective.
- Identify the resulting strategic challenges.
Most firms identify the three most important stakeholder groups as customers, employees, and stockholders.
The Unique Role of Stockholders
Among stakeholders, stockholders' position is unique because the stockholders are the legal owners of the firm as well as the providers of funds. Their unique position leads to an emphasis on satisfying the needs of this key stakeholder group.
- The money provided by stockholders is called risk capital, because the stockholders are making a risky investment in the firm with no guarantee of returns or even the preservation of their original investment.
- Because of their willingness to assume risk, managers are obliged to reward stockholders by pursuing strategies that maximize returns to them.
- When employees become stockholders too, for example through employee stock ownership plans (ESOPs), the importance of maximizing stockholder return grows.
Profitability, Profit Growth, and Stakeholder Claims
Companies can satisfy stakeholder claims by increasing profitability.
- Managers can best serve the interests of stockholders by increasing profitability. Stockholders receive returns as dividends and as appreciation in share value. Increasing profitability (that can be measured by ROIC) tends to both increase the funds available for dividends and to drive up the value of the stock.
- Managers need to find the right balance between current profitability and profit growth (future profitability).
- Profitability satisfies the claims of several other stakeholder groups, in addition to stockholders. Higher profits generate more funds for paying high salaries and offering more benefits to employees, for satisfying debt obligations to creditors, and for philanthropic activities, which benefit local communities and the general public.
- The cause-and-effect relationship between profitability and satisfying stakeholder claims shows that profitability must be the cause, leading to the ability to satisfy. Once a company is profitable, then it can satisfy stakeholders. In return, satisfied stakeholders provide more generously for the firm, which leads to further increases in profitability. Thus the process is a self-reinforcing cycle.
Not all stakeholder groups are satisfied by high profitability.
- Suppliers want to sell to a profitable company, because it will pay for what it receives. Customers want to buy from a profitable company that will exist long enough to provide customer service and additional sales. However, neither group wants the firm to profit at their expense.
- Governments expect every company to make profits only within the limits set by law. The general public expects companies to profit in a manner consistent with societal expectations.
- Every stakeholder group disapproves of the unfettered pursuit of profit, if it leads to unethical or illegal behavior.
Practice Question 1True or False? All stakeholder groups are satisfied by high profitability.Correct Answer: False
For example, suppliers want to sell to a profitable company, because it will pay for what it receives. Customers want to buy from a profitable company that will exist long enough to provide customer service and additional sales. However, neither group wants the firm to profit at their expense.
Practice Question 2Which group is NOT a stakeholder of a firm?
C. Competitors.Correct Answer: C
Practice Question 3Internal stakeholders do NOT include:
C. Stockholders.Correct Answer: A
Unions provide productive employees.
Practice Question 4The three most important stakeholder groups are:
Correct Answer: I, II and IV
Practice Question 5Sotheby's and Christie's, the two largest fine art auction houses in the world, were earning low commissions in the 1990s, as sellers negotiated simultaneously with both firms for the best rates. Sotheby's CEO, Dede Brooks, secretly met with CEO Christopher Davidge of Christie's, to establish together a fixed, nonnegotiable rate structure. This had the effect of illegally fixing prices and reducing competition. The deal was exposed, and the auction houses paid settlements to sellers that totaled $512 million, in addition to federal fines. The conspirators, and the chairmen that were their superiors, lost their jobs and received jail time or probation from federal courts. Which stakeholders were hurt by the price fixing action?Correct Answer: In this case, illegal price fixing led to higher commissions paid by sellers. It also might have contributed to buyers paying higher prices, as sellers tried to recover some of their additional expenses. Finally, it was not in the best interests of shareholders, because the lawsuits and fines led to lower profitability.
Practice Question 6Pursuing strategies that maximize the long-run profitability and profit growth is generally consistent with satisfying the claims of various stakeholder groups. These stakeholder groups include:
IV. Local communities and general publicCorrect Answer: All of them.
Practice Question 7Which statement is true?
I. In general managers should favor profit growth over current profitability.
II. In general a company can always satisfy the claims of all stakeholders if it chooses to do so.Correct Answer: Both are false.
I: They cannot have too much emphasis on either. They should strive to find the right balance.
II: The goals of different stakeholders often conflict.
Practice Question 8Which group is considered to be external stakeholders?
A. Employee stockholders.
B. Institutional stockholders.
C. Creditors.Correct Answer: C
Creditors provide funds and expect repayment and interest.
Practice Question 9Which stakeholders are NOT classified as internal stakeholders of a firm?
A. II and IV
B. I and III
C. II and IIICorrect Answer: A
II and IV are external stakeholders.
Practice Question 10The three most important stakeholders identified by most firms are:
A. I, II and III
B. I, III and V
C. II, IV and VICorrect Answer: B
Most firms find they must satisfy these three stakeholder groups: customers, employees and stockholders.
Study notes from a previous year's CFA exam:
a. compare interests of key stakeholder groups and explain the purpose of a stakeholder impact analysis;