Two Very Different Ways to Run a Company

Which of these two companies would you rather invest in?

The first boasts in its annual report that it has a single goal: "maximizing shareholder value." A few lines later, it promises: "We are deeply committed to building the value of the Firm ... in everything we do, we are constantly identifying and evaluating ways to add value."

Its CEO repeats the line frequently in conference calls with analysts. Between discussing ways to boost the company's share price, he reminds that "our goal is simple; that's to create value for our shareholders."

The other company takes a different approach. Its annual report states that the business "was not originally created to be a company." Customers that are key to its future "believe in something beyond simply maximizing profits," it reads.

Its CEO once stated bluntly, "We're definitely not in it for the money," and admitted to a friend that "I don't know business stuff." One analyst wrote that the company's management simply "doesn't care that much about making money," which is probably true.

What are these companies? The first is Lehman Brothers. The second is Facebook (NAS: FB) .

The irony here is too much to ignore. Lehman is responsible for the largest bankruptcy in history, and it ran its shareholders into the ground. Facebook pulled off one of the largest IPOs ever, holds the richest valuation among large-cap stocks, and has created more millionaires and billionaires in a short period of time than perhaps any company in the history of business.

There's something massively important to learn from that comparison. The goal of any public company should be to create value for its shareholders, but how that goal is prioritized and achieved varies wildly.

To keep using Lehman and Facebook as examples, it seems there are two distinct ways companies can attempt to create value for shareholders:

  1. The Lehman Brothers way: Start with the goal of making profit, and then find products that enable that goal.
  2. The Facebook way: Start with the goal of delivering amazing products, and then profit from those products naturally.

Facebook CEO Mark Zuckerberg says it better: "By focusing on our mission and building great services, we believe we will create the most value for our shareholders and partners over the long term -- and this in turn will enable us to keep attracting the best people and building more great services. We don't wake up in the morning with the primary goal of making money, but we understand that the best way to achieve our mission is to build a strong and valuable company."

My examples of Lehman and Facebook are cherry-picked, of course. But there are plenty of others. Amazon (NAS: AMZN) has consistently sacrificed short-term profit in the name of creating the best products in the industry. Far from hurting investors, this has caused its shares to rise tenfold in the last decade. General Motors (NYS: GM) , on the other hand, lost its way when the "car guys" were overrun by the "bean counters" and profits took precedence over products, as former vice chairman Bob Lutz put it. He elaborated last year:

Leaders who are predominately motivated by financial reward, who bake that reward into the business plan and then manipulate all other variables in order to "hit that number," will usually not hit the number, or, if they do, then only once. But the enterprise that is focused on excellence and on providing superior value will see revenue materialize and grow, and will be rewarded with good profit. ... Is profit an integral part of the business equation and a God-given right, no matter how compromised the product or service? Or is the financial result an unpredictable reward, bestowed upon the business by satisfied customers?

Two years ago, Roger Martin, dean of the Rotman School of Management at the University of Toronto, tackled the meaning of that last question in a paper for the Harvard Business Review. According to Martin, the "need to swear allegiance to 'maximizing shareholder value'" began in earnest in the late 1970s. Profits had always been (and will always be) the end goal of a company, but views on them have changed over the years; something that was once seen as a reward for serving customers became the first priority.

In his book Origins of the Crash, Roger Lowenstein describes how the change in thinking materialized over the last three decades. Stock-based compensation increased dramatically throughout the 1980s and '90s -- as did leverage, acquisitions, spinoffs, and accounting games designed to maximize profits. "The total of companies forced to restate earnings because of accounting errors rose from a handful a year in the early '80s to more than 150 a year by the late '90s," writes Lowenstein.

But while the prioritization of profits shifted, there was no meaningful jump in shareholder returns. The S&P 500 (INDEX: ^GSPC) returned 10.8% per year from 1950 to 1980 and 10.9% a year from 1980 to 2010 (both periods include dividends). The era of maximizing shareholder returns seems to have produced no added benefit over the previous period. Indeed, according to an exhaustive study by Deloitte, the average return on assets and average corporate life expectancy has declined over the last four decades.

These are enormously complicated topics prone to generalization and confusion of correlation with causation. But the broader message, I think, is important. Lehman obsessed over profits and failed miserably. Facebook has obsessed over products and flourished -- with incredible profits and shareholder wealth as a result. Neither is likely a coincidence, and the comparison says a lot about what it takes to become a great company.

Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics.

At the time this article was published Fool contributorMorgan Houseldoesn't own shares in any of the companies mentioned in this article. Follow him on Twitter @TMFHousel.The Motley Fool owns shares of Motley Fool newsletter services have recommended buying shares of General Motors and The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

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