The Financial Objective: What a Company Is Trying to Maximise

A company's financial objective is to maximise the value of the owners' claim on it, over the long run, inside the law and inside what it has already contracted to do. Every clause there is load bearing. Owners means whoever is paid last. Long run means most of the value lies past any forecast. Inside means the objective removes nothing that was already binding.

The objective as stated is longer than the version usually heard, and the extra length is the entire point. Stripped back to four words it becomes something nobody can disagree with and nobody can test. Kept with its three qualifiers it becomes a statement that can be held up against a real decision and can fail. Each clause below is taken apart in turn, given a rupee figure on one invented manufacturer, and then set against the three standing objections in their strongest form rather than their easiest one.

Why does a company need exactly one financial objective?

Start somewhere ordinary. A household running a small tailoring shop wants three things at once: to earn more this month, to keep the two people it employs, and to stay on good terms with the cloth wholesaler who extends it credit. Most months those three pull the same way. The month they do not, somebody has to decide, and there is no rule inside the list that says which of the three wins. The list cannot settle its own argument.

A company is the same shape with more zeros. An objective that is a list of three things is not an objective. Every decision that trades one item against another has to be referred upward to somebody who is quietly applying a fourth rule nobody wrote down. The value of the ownership claim survives as the single item for a specific and unromantic reason: it already contains the others rather than ignoring them. Value charges for the capital that was used. Value counts every future year rather than only the near ones. And because a riskier stream is worth less than a safer one of the same size, value prices the chance that the plan does not work.

Value cannot show up in this quarter's reporting pack. The one weakness is where all three of the standing objections find their footing, and none of them is an attack on the arithmetic. Each attacks whether a thing that cannot be observed can honestly be called the objective at all.

What does the objective look like when it is written out in full?

Here is the sentence, split so that each clause sits on its own line with the question it answers. The full sentence works as a test rather than as a slogan: given any decision a company is about to take, the clause that the decision is being judged against can be pointed at.

The worked figures in this guide belong to Sankalp Industrial Systems Limited, an invented listed manufacturer of industrial valves, precision castings and the aftermarket parts and service that go with them. Sankalp has one subsidiary, Sankalp Coatings Private Limited, also invented, of which it holds 75.0 per cent and whose results it consolidates in full. Every figure is an illustration attached to that invented company.

Whose value is it, and who stands in front of the owners?

Go back to the tailoring shop. At the end of a month, money comes in and then leaves in a fixed order: the cloth wholesaler is paid because there is an invoice, the two employees are paid because there is an agreement, the electricity is paid because otherwise the machines stop. Whatever remains belongs to the household. Nobody negotiated that last amount, and nobody promised it. The household's share is what is left.

The owners of a company sit in that last position. Last position is the whole content of the phrase the owners' claim: not the largest claim, not the most important claim, but the one settled after every other one has been. Sankalp's ordering, at the figures the record locks, runs like this. Rs 6,00,00,00,000 of gross debt across three tranches is a promise with dates attached, and the lenders are paid whether the year went well or badly. A further Rs 60,00,00,000 sitting on the consolidated balance sheet is not the group's at all. One quarter of Sankalp Coatings Private Limited is held by somebody else, that quarter carries its own claim, and no amount of good performance by the coatings business converts it. The remainder is the owners' position: 20,00,00,000 shares at an observed Rs 90.00, being a market capitalisationThe number of shares in issue multiplied by the price each one last changed hands at. of Rs 18,00,00,00,000.

Notice the red sliver in that drawing. The sliver is deliberately thin because Rs 60,00,00,000 is small against Rs 24,60,00,00,000 of total claims, and deliberately drawn because a small claim that quietly stops being somebody else's is one of the easiest errors in this whole subject. ConsolidationAdding a controlled company's results into the parent's statements in full, line by line, and then showing the outside share separately. puts every rupee of the coatings subsidiary's cash flow into one column, and one quarter of that column has belonged to somebody else the entire time. The claim appears on the balance sheet as minority interestThe part of a controlled company that the group does not hold, shown as a separate claim because the results were added in full. of Rs 60,00,00,000, and the same fact shows up in the profit line as Rs 6,00,00,000 a year of Sankalp's Year 0 profit that is not attributable to its owners.

Why write the objective around the party that is settled last?

Writing the objective around the party settled last sounds like favouritism and is not. Ask what happens to each claim when the business does unexpectedly well. The lenders on Sankalp's second tranche are promised 8.50 per cent a year on Rs 2,00,00,00,000 of listed debentures. If the company has an extraordinary decade, those lenders receive 8.50 per cent. If it has a poor decade and still pays, they receive 8.50 per cent. Their position is fixed by the contract in both directions, and improving the business does not improve their claim by one rupee.

The same is true, in its own way, of most of the other parties. An employee's pay is set by an agreement. A supplier's price is set by an invoice. A tax charge is set by rules somebody else writes. The owners are the only party whose position moves with the whole outcome rather than with a term negotiated in advance. An objective written around them therefore improves whenever the business as a whole improves. Written around the lenders instead, it produces a company that should hold as much cash as possible and never invest in anything, because that maximises the safety of a fixed claim. Written around this year's employees, it produces a company that never closes a loss making line. Neither of those is a bad instinct; both are simply objectives for somebody, and the objective for the residual position is the only one that cannot be satisfied without the business itself being worth more.

Say the honest part too. The claims structure establishes that the owners are the right party to write an objective around. The same structure does not establish that everybody else has been treated well, and the first of the three objections takes that up rather than waving it away.

Over what horizon, and can that be put in a number?

The horizon can be put in a number, and the number is a surprising one. Sankalp's forecast runs five years out, and each of those years took real work behind it: a revenue path, a margin, a capital spending plan, a working capital assumption. Here is what the operating business is forecast to throw off in each one, and what each of those amounts is worth in today's rupees once the company's own 12.00 per cent rate is applied at year end rather than mid year.

Set that total beside the whole. The modelled enterprise valueThe value of the whole operating business, before separating what belongs to lenders from what belongs to owners. of this company is Rs 21,28,13,79,094. So the entire five year build, every assumption in it, accounts for Rs 4,68,41,43,564 of that. How the 12.00 per cent is built, and how the years past the forecast are valued, are each settled elsewhere; the one thing taken from the model here is the ratio between those two totals.

Long run is not a mood in the objective. On this company it is 77.99 per cent of the value sitting in years for which no forecast exists. The part of a value that stands in for everything past the explicit forecast is called the terminal valueThe single figure that stands in for every year past the last one the forecast reaches. The terminal value is built separately and rests on its own assumptions., and Aswath Damodaran is the source usually named for the argument that such a figure has to be made consistent with the growth and the reinvestment it quietly assumes. Building that figure is covered separately. The consequence is blunt. Read over one year, the objective measures roughly four per cent of the thing it claims to be maximising, and any decision that lowers this year's cash gets called a failure of the objective even when it is the objective being served.

Subject to what, and what does a constraint actually cost?

Because it sounds like a disclaimer, the third qualifier is the one people forget hardest. It is not. A constraint is a very specific object: it is something that removes a decision rather than informing one. The test is simple and mechanical, and it is whether the answer no is available. If it is, the thing is a choice, and the value test settles it. If it is not, the thing is a constraint. A value test still runs, and its answer cannot be acted on by anybody.

Sankalp has a real one on its list of capital items, and it is worth setting out with every reading a company would normally use to judge a discretionary spend.

Read that table as a choice and it is a clear refusal on every line. The plant is being built regardless.

A constraint is not a lower priority than the objective and it is not in tension with it; it sits outside the set of things the objective is allowed to decide. The right question about the effluent plant is not whether to build it. The question is how to comply for the least money, and that one is a genuine value question with a real answer. Households do this constantly without naming it. Nobody runs a return calculation on the school fees. The household does work out which school, and how the fees are met, and that is exactly the shape of question the objective is entitled to ask about a mandatory item.

What are the three standing objections, in their strongest form?

An objective this old attracts objections, and the honest way to handle them is to notice that they are not one complaint. The objections are three, they attack three different clauses, and mixing them together is how each one gets answered badly. Separated, they show which of the three the record here can settle and which it cannot.

Objection one: it privileges a single claimant

The objection says the objective names the owners and leaves out everybody else with an interest in the company. Put in its strongest form it is not sentimental at all: it says the company's employees, its suppliers, the town its plant sits in and the customers who depend on its valves all bear consequences from its decisions, and none of them appears in the sentence.

The reply worth making is the structural one. Every other party named there holds a prior claim, and prior claims are settled first by law or by contract rather than by the objective. Settling prior claims first is not a courtesy but the ordering drawn above, where Rs 6,00,00,00,000 of lender claims and Rs 60,00,00,000 of outside holders' claims are settled before a single rupee reaches the owners. A stakeholderAnyone who bears a consequence from what a company does, whether or not they hold a claim on it. who is also a contracting party is protected by the contract, and the constraint clause is where the rest of that protection lives.

The structural reply is real, and it is not complete, and presenting it as a knockout does the objection a favour it does not deserve. It is incomplete because not every consequence a company creates is somebody's contract, and where there is no contract and no rule, the objective as stated is silent. The honest position is that the objection identifies a genuine gap, that the constraint clause is where a legal system fills it, and that arguing about how wide that clause should be is a live argument rather than a settled one.

Objection two: it leans on a price, and the price and the model disagree

In practice the objective is usually restated as maximise the share price, and that restatement quietly assumes the observed price is carrying good information about the value. Sankalp puts that assumption in plain view. Its traded enterprise value is Rs 22,40,00,00,000. Its own discounted cash flow, on its own assumptions and at its own 12.00 per cent, gives Rs 21,28,13,79,094. The traded figure is Rs 1,11,86,20,906 higher. Measured against the modelled figure, that is 5.26 per cent.

Now the part that matters. There is a disciplined way to state a gap like that and an undisciplined one. The undisciplined version picks a winner. The disciplined version asks what the model would have to assume to arrive where the price already is, and states only that. Hold the discount rateThe rate at which a rupee expected in a future year is converted into a rupee today. The rate is built separately and is held fixed here. at 12.00 per cent, and terminal growth has to be assumed at 5.80 per cent in place of 5.00. Leave growth at 5.00 per cent instead, and the rate has to come down to 11.67 per cent from 12.00.

Stating the gap as 80 basis pointsHundredths of one per cent. Eighty of them is 0.80 of a percentage point. on the growth assumption, or 33 on the rate, is the only statement the two figures actually support, because it describes an assumption and every other version is a verdict. Which of the two figures is right is not settled here. The traded figure sits inside the range of values this subject produces for the company, and that is where the matter stops. Where the objection lands, and it does land, is that an objective read as the share price is only as informative as the price is, and this pair is a demonstration that the two can differ by a real amount without either being wrong.

Objection three: it cannot be seen this quarter, so something else gets used instead

The third objection is the one with teeth, and it is worth stating in its uncomfortable form. Value is not observable on a reporting timetable. A company has to report something every three months. Because 77.99 per cent of the value lives in years that have not happened, the thing it is supposedly maximising produces no reading on that schedule. So a stand-in gets used. Usually the stand-in is an earnings measure, and an earnings measure is produced anyway.

Once the stand-in exists, two things follow that nobody chose. The stand-in becomes what people are measured on, promoted on and paid on. And the stand-in sits at some distance from the thing it replaced. Closing that distance and improving the underlying thing are different activities that look identical from outside.

The gap between the objective and the measure used for it is not a mistake anybody made; it is the price of needing a reading on a schedule the objective does not keep. Jensen and Meckling, in their 1976 paper in the Journal of Financial Economics, are the usual reference for the general problem of a person deciding on behalf of somebody else while being measured on something that is not that person's objective. The cost of that conflict, how it is measured and what is done about it are covered separately. Objection three does not claim the objective is wrong, so no defence of the objective touches it. The claim is that the objective is not the thing being managed.

What does the objective not authorise?

Three things, and each of them is a live misreading rather than a theoretical one.

The objective is not a profit target. Profit is a measure and the objective is not a measure, and the horizon clause is what separates them: a company where 77.99 per cent of the value sits past Year 5 can raise this year's reported profit by damaging most of what it is worth. Profit and value can move in opposite directions, and the arithmetic showing that happen is worked separately rather than compressed into a single paragraph.

The objective is not a mandate to do anything the arithmetic favours. The constraint clause is not a preference that yields when the numbers get large enough. The effluent plant is the demonstration in the other direction, but the same clause runs the other way too: an item that clears every value test and breaches a contract the company signed is outside the set of things the objective is permitted to choose.

And it is not a permission slip. The four word version enables one particular misuse, and it is worth naming plainly. Because maximise shareholder value cannot be shown to have been breached in any particular case, it can be offered as the reason for almost any decision. A sentence that cannot fail cannot justify anything either.

Who reads the objective from outside, and what do they do with it?

Four readers use this sentence in four different directions, and seeing that is what turns it from a definition into something usable.

A lender reads it as the thing to be fenced. A lender holding Sankalp's Rs 3,00,00,00,000 term loan knows the owners' objective is to make the residual as large as possible, and knows that some routes to a larger residual make the lender's own fixed claim less safe. The conflict is not an accusation but a structural fact about the two positions, and it is the reason a loan agreement carries conditions at all. A lender is not trying to stop the objective being pursued; a lender is trying to fence the small set of ways of pursuing it that transfer risk onto a claim that was priced without it.

An analyst reads it as a checklist against a management statement. When a company says a decision creates shareholder value, the three qualifiers give three questions with real answers. Whose value, and does the answer survive the minority interest and the debt? Over what horizon, and is the improvement in years one and two being funded out of years six onward? Subject to what, and is the item actually optional? Most weak claims fail at one of those three without any modelling at all.

An owner reads it as the thing a reported number is not. The Rs 6.90 of Year 0 earnings per share is a measure that gets reported. The objective is the thing the measure stands in for, and objection three above is a warning that the two can drift while every reported figure improves.

And a household reads a smaller version of the same sentence without naming it. A one-room shop that skips restocking has a very good month and a thinner next year. A household that defers a roof repair has a cheaper year and a larger bill later. In both cases the reported number improved, the qualifiers were dropped, and nothing in the arithmetic said anything was wrong. Dropping the qualifiers is the whole of the lesson, and the rupee figures above are that same lesson at a scale where somebody writes it down.

Sankalp Industrial Systems Limited and Sankalp Coatings Private Limited are invented.
Educational material. Not advice on any investment, tax, budget or market position.