The primary objective of the Finance manager is always to increase the wealth of the shareholders in long term.
And this objective is also compared with the profit maximization objective of the corporation and almost all the authors believe that Wealth maximization is superior objective than Profit Maximization.
But the question here is that What we understand by Wealth Maximization objective.
Is it:
1. Maximization of Market price of the share or,
2. Maximization of Intrinsic Value of the share
Let us first read the definition of the above two categories:
1. Market price of the share: As per “Investopedia”
The current price at which an asset or service can be bought or sold. Economic theory contends that the market price converges at a point where the forces of supply and demand meet. Shocks to either the supply side and/or demand side can cause the market price for a good or service to be re-evaluated.
In other words Market price is the price that we generally observes in financial market which is guided by the demand and supply of the share/stock.
2. Intrinsic Value of Share:
a) As per “Investopedia”
The actual value of a company or an asset based on an underlying perception of its true value including all aspects of the business, in terms of both tangible and intangible factors. This value may or may not be the same as the current market value. Value investors use a variety of analytical techniques in order to estimate the intrinsic value of securities in hopes of finding investments where the true value of the investment exceeds its current market value.
b) As per Wikipedia
Intrinsic value refers to the actual value of a company or stock determined through fundamental analysis without reference to its market value. It is also frequently called fundamental value. It is ordinarily calculated by summing the future income generated by the asset, and discounting it to the present value.
From the above definitions of “Market value of share” and “Intrinsic/Fundamental Value of share” it is clear that both are different in nature.
Now our fundamental question is that, In which direction a finance manger should route his efforts:
a) In maximizing the Market value of share or
b) Intrinsic/Fundamental value of share.
To understand this, We should take an example:
For example, suppose a Company’s stock price is equal to its fundamental price of $50 per share. What would happen if company is going to undertake major expenditures i.e Major Repair costs for the damaged pipe line in the future. If investors were told about the major repair costs facing the company, the market price would immediately drop to a new fundamental value of $45. But if investors were kept in the dark, they might misinterpret the higher-than-expected current earnings, and the market price might go up to $52. Investors would eventually understand the situation when the company later incurred large costs to repair the damaged pipe lines; when that happened, the price would fall to its fundamental value of $45.
Consider this hypothetical sequence of events. A company’s managers deceived investors, and the price rose to $52 when it would have fallen to $45 if not for the deception. Of course, this benefited those who owned the stock at the time of the deception, including managers with stock options. But when the deception came to light, those stockholders who Still owned the stock suffered a significant loss, ending up with stock worth less than its original fundamental value
In addition, the managers’ deception would damage the company’s reputation, making it harder to raise capital in the future.
Therefore, when we say management’s objective should be to maximize stockholder wealth, we really mean it is to maximize fundamental price of the firm’s common stock, not just the current market price. Firms do, of course, have other objectives; in particular, the managers who make the actual decisions are interested in their own personal satisfaction, in their employees’ welfare, and in the good of their communities and of society at large. Still, for the reasons set forth in the following sections, maximizing intrinsic stock value is the most important objective for most corporations.
(The author is the member of ICAI. His areas of interest include Finance. For any queries and suggestions he can be approached at Email Id: arvindagarwall@yahoo.co.in)
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