Public Companies And The Law Of Diminishing Marginal Returns

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In Economics, there is a famous Rule called The Law Of Diminishing Marginal Returns and one of the ways it is explained is using the example of Glasses full of Beer. Think of being thirsty. If you go for a beer, the first gulp will taste best and bring the most benefit. In economists lingo, the return is high. Any further gulp will taste good as well, but not as good as the one before. Thus, the return diminishes. You will reach a point, when you had enough beer. This time, the sip will not do any benefit to you. The return is 0. If you - nevertheless - go ahead with drinking beer, the returns will turn negative. The more you sip, the more you will get drunk.

I have been thinking a lot lately about public companies. As someone who use to teach corporation and securities law, I take for granted the fact that the public company is the most efficient way:

• For a company to raise capital.
• For an investor to put his money in the hands of expert management that will ensure his investment grows by generating value.

The whole legal concept of public companies and the stock markets is that this tool will allow the free agents to create more value for society. And in theory, this is a great idea. If I have the money but not the ability to manage a company, I hire other people to manage my company and find a bunch of other people like me. The managers, who are experts in creating value, manage our assets, and we can profit from the value generation, by enlarging the business on one hand and by taking dividends on the other hand. This in turn creates value for the society as a whole.

But as always, there is a difference between theory and practice.

The problem is that the structure of public companies and the stock market creates the wrong incentives. Instead of investors looking for expert managers to ensure their investment grows by creating more value, the investors (directly or indirectly using all kinds of funds) are searching to make profits out of the volatility of the markets. When you have 1,000$ (or less) invested in a company, you are not interested in the value generation or in drawing dividends, but in the impact on the value of the share, so you can sell it.

This in turn puts pressure on the management to perform for the short run and to take steps and risks that a company without these incentives would not have taken. It creates a culture of a race after growth and of ignorance to the cash at hand. The short run outlook does not allow companies to sustain their profits over time and thus, does not create value for their investors and the society. I think that from society’s outlook, the current structure of the markets endangers the goal for which society has created these markets in the first place.

What is interesting is that the bigger the market, the more diversified it is, the more people are in it, the worse this phenomenon gets. And our markets are getting bigger, because of the internet, globalization and capital in emerging markets. I think that stock markets have a diminishing marginal return and we have crossed the point where they become less effective the bigger they get. Perhaps the near future will lead to a surge in the number of private companies.

From what I have seen in the last few months in the world and from the little I covered in my MBA (at AGSM, Sydney), if I was the leader of a private company thinking to go public today, I would reconsider. Maybe try to raise money in different ways or from a small number of strategic investors, but avoid going public at any cost. That is the most responsible thing to do, as a manager and as responsible citizen of society.

Note: This article has been reproduced with explicit permission from the author. Check the original post here.

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posted by eladsherf in B-School Experiences, Business |