What Is Fisher's Separation Theorem?
Fisher's Separation Theorem is an economic theory that postulates that, given efficient capital markets, a firm's choice of investment is separate from its owners' investment preferences and therefore the firm should only be motivated to maximize profits. To put it another way, the firm should not care about the utility preferences of shareholders for dividends and reinvestment. Instead, it should aim for an optimal production function that will result in the highest profits possible for the shareholders.
By disregarding the desires of its shareholders in favor of maximizing company value, Fisher's Separation Theorem argues, the company will ultimately succeed in providing greater long-term prosperity for both managers and shareholders.
- Fisher's Separation Theorem says a company's managers and shareholders often have different goals.
- The theorem argues that management's main goal should be to increase the company's value to the maximum extent possible. While this trumps the immediate priorities of shareholders, who are looking to benefit from dividend payouts and share price rises, it ultimately benefits them.
- The theorem is named after Irving Fisher, a neoclassical economist and Yale University professor, who developed it in 1930.
- Fisher's writings and teachings have influenced many other economists and economic theories, including the Modigliani-Miller theorem.
How Fisher's Separation Theorem Works
The starting point for Fisher's Separation Theorem is the basic notion that managers of a firm and its shareholders have different objectives: Stockholders have preferences that suit their needs—or, in Theorem lingo, "consumption objectives." But managers of the firm have no reasonable means of ascertaining what investors' individual needs are. In addition, shareholders often lack the understanding of what the business needs to make the decisions that will benefit the company in the long term.
So, Fisher's Separation Theorem says, managers should ignore what investors want. Instead, the main goal of a corporation and its management should be to increase the company's worth to the maximum extent possible. The theorem argues that the need to increase company value trumps the priorities of shareholders, who are looking to benefit from dividend payouts or the selling of shares.
As such, management would do better to focus on productive opportunities. In doing so, they should bear in mind:
- The firm's investment decisions are independent of the consumption preferences of the owner(s) (or shareholders, in public companies)
- The investment decision is independent of the financing decision
- The value of a capital project/investment is independent of the mix of methods—equity, debt, and/or cash—used to finance the project
Executives who make investment decisions that enhance the business and its core operations should assume that, in the aggregate, investors' consumption objectives can be satisfied if management maximizes the returns of the enterprise on their behalf. In other words, by increasing profits and the company's worth, the stockholders will ultimately benefit, and be happy. A win-win for everyone, managers and investors alike.
Fisher's Separation Theorem is also known as the portfolio separation theorem.
Who Was Irving Fisher?
Fisher's Separation Theorem is named after Irving Fisher, who developed it in 1930. It was published in his work The Theory of Interest.
Irving Fisher (1867-1947) was a Yale University-trained economist who made numerous contributions to neoclassical economics in the studies of utility theory, capital, investment, and interest rates. Neoclassical economics looks at supply and demand as the primary drivers of an economy.
Fisher was a prolific writer: From 1912 to 1935, he produced a total of 331 documents—including speeches, letters to newspapers, articles, reports to governmental bodies, circulars, and books. Along with The Theory of Interest, The Nature of Capital and Income (1906) and The Rate of Interest (1907) were seminal works that influenced generations of economists.
Fisher's Separation Theorem was an important insight, widely regarded as laying a foundation for many financial theories.
For example, it served as the foundation for the Modigliani-Miller Theorem, first developed in 1958, which stated that, given efficient capital markets, a firm's value is not affected by the way it finances investments or distributes dividends. There are three main methods for financing investments: debt, equity, and internally generated cash. All else being equal, the value of the firm does not vary depending on whether it primarily uses debt versus equity financing.