IN DEFENSE OF MBAS Businessmen grouse about them, but the best ones have financial skills that corporations badly need.

(FORTUNE Magazine) – Dumping on MBAs has become increasingly popular in recent years, both in the popular press and in specialized publications such as the Harvard Business Review. Newly minted MBAs, the critics say, are too ambitious, too impatient, and not worth the high salaries they command. I often hear similar complaints from senior managers and corporate directors. My short answer to these criticisms is that MBAs need no defense because their offense has been so successful. The marketplace has spoken: new MBA graduates with a few years' work experience command salaries as high as $70,000 a year, and even without on-the-job experience the top graduates from the premier business schools start at around $50,000. Consulting firms, investment banks, commercial banks, and large industrial companies presumably court these MBAs with such princely offers because their predecessors have proved to be worth it (and, presumably, because employers aren't really eager to find patient, unambitious young managers). My free-market orientation convinces me that this rebuttal is correct, yet the disappointment with MBAs is obvious and widespread. Why all the grousing from the managers paying these big salaries? I suspect that it arises from experience with the mediocre graduates who come out of even the best schools, and with the legion of MBAs churned out of lesser institutions. Some employees always prove disappointing, whether they have MBAs, B.A.s, or engineering or law degrees. But the smart students coming out of the top schools are equipped with new financial skills that can help any company improve its performance. How can employers monitor the quality of business education and identify the MBAs who deserve the accolades and the dollars? The easiest way is to stick with graduates of the schools that have been primarily responsible for disseminating the new learning in finance that has developed over the last two decades. By my lights, these schools are the University of Chicago, MIT's Sloan School, the University of Rochester, and UCLA. Moving strongly in this direction are Stanford, Wharton, Berkeley, Northwestern, Carnegie-Mellon, Columbia, New York University, and Harvard. The different ways that business schools train managers explain why MBAs are not created equal. Most business education falls into two broad categories. The first has a descriptive, institutional bent. Its purpose is to provide students with knowledge of current business practices, conventions, and -- though certainly not the intent of its proponents -- popular myths. This approach, which prevails at most state universities and many other schools, often is combined with an excessive reliance on the case study method pioneered at Harvard. Case studies, which force students to work through abbreviated versions of actual business situations, are designed to produce experienced decision makers. The exercise of making decisions under pressure is supposed to generate the best managerial talent, regardless (so it seems) of the validity of the reasoning underlying the decision. Business schools copied the case study method used in law schools, where it has long been extremely useful. In law schools, going to past cases means going to original sources, just as rigorous historians go to original documents. But, as Professor James Lorie of Chicago has pointed out, the use of cases in business education is little more than a vicarious and attenuated apprenticeship. And apprenticeship ceased long ago to be the predominant mode of education in almost all serious disciplines. By contrast, the second category of business education is fundamentally scientific in its methods. Known as the Chicago school or quantitative approach, it attempts to imbue the student with a valid theoretical understanding of business decisions -- not only of how such decisions usually are reached, which is where the institutional approach usually leaves off, but how they ought to be reached. The quantitative approach begins with the assumption that those business practices that have survived the test of time have good economic justifications. It then attempts to separate the real economic reasons from the popular myths. THIS APPROACH recognizes that before the student can adapt decision-making skills to specific, unforeseeable situations, he or she needs a solid grounding in such disciplines as economics, statistics, and accounting. The goal is to provide the student with a coherent body of objective, broadly applicable principles. Such principles are not based on ad hoc conclusions generated by a set of hand-picked cases or a collection of war stories passed down by successful veterans of the business world. They are the product of applied economic logic supported by empirical tests. Armed with scholarly studies subjecting masses of data to rigorous analysis, the student comes away with a reliable guide to how a variety of decisions can be expected to affect stock values. To illustrate the fundamental difference between the two approaches, consider one of my favorite managerial conundrums: what is the best dividend policy? Practitioners of the institutional approach usually impress upon their students the conventional wisdom that, given a fixed level of earnings, investors prefer that corporations distribute more of those earnings as dividends. All things being equal, higher payout ratios supposedly mean higher stock prices. After all, it doesn't take a financial wizard to determine that the market responds favorably to dividend increases and unfavorably to decreases. A business school with a scientific orientation approaches the question quite differently. First, the student reads a classic 1961 paper by Franco Modigliani of MIT and Merton H. Miller of Chicago putting forth the proposition that dividends are irrelevant to how the market values a stock. The student then reads an extensive body of empirical tests supporting that theory, and supporting the proposition that increases and decreases in dividends matter simply because they convey information about management's assessment of future earnings. Where does all this theory and evidence leave the future corporate decision maker? The purpose of the exercise is to foster a propensity to distinguish between financial illusion (in this case, the popular view that investors prefer dividends to capital gains) and market reality. After all this you might say, ''OK, Stern, this is well and good. But we need only one MBA to make your case, and we only deal with dividends in January. Should I hire just one and send him on vacation for the rest of the year?'' My answer is that, especially in finance, the kind of training pioneered at the University of Chicago has implications for a broad range of decisions. A revolution in the theory of corporate finance has been under way since the early 1960s. The study of finance, grounded in sound economic logic and bolstered by sophisticated statistical methods, has made steady progress toward achieving the predictive power of a hard science. Finance scholars are challenging much of the accounting-oriented intuition that continues to pass for the collective wisdom of Wall Street. Properly applied, the new insights can provide managers with a more sensible basis for setting corporate goals, evaluating divisions and subsidiaries, choosing among investment opportunities, pricing acquisitions and divestitures, structuring incentive compensation plans, finding the ideal capital structure, and communicating with the investment community. The modern theory of corporate finance is, at bottom, a change in the theory of valuation. To the extent that managers view their function as providing the maximum returns for stockholders, all financial decisions are grounded in some theory of capital-market pricing. How managers use the assets at their disposal and what they tell investors depend on their understanding of how the stock market works. The rise of modern finance theory has brought about a confrontation between two very different views of how the capital markets value securities. This, in turn, has given rise to two distinct philosophies of management. The traditional view holds that stock prices are determined primarily by reported earnings. Executives who subscribe to this ''accounting'' model of the firm see their goal as maximizing reported earnings per share. The rival view, the ''economic'' model, holds that the market value of any security is determined by the after-tax cash flows it provides. That is, the tricks that accountants can play with things such as inventory valuations don't really matter to the stock market unless they affect some real variable like taxes. According to this view, accounting profits offer a good measure of performance only insofar as they reflect real cash profits. When reported earnings differ significantly from cash flows, they distort performance and provide an unreliable guide to value. RESEARCH IN FINANCE and accounting has produced a large body of evidence attesting to the ability of the stock market to penetrate accounting fictions. The first implication, which business students schooled in the quantitative approach well understand, is that earnings per share don't count; cash flows count. The second implication is that public corporations should be run exactly as if they were private -- to maximize not earnings but cash flows. When a company properly communicates this approach to the market, the sophisticated investors whose assessments have the greatest influence on share prices take good care of the company's stock. The scientific revolution in finance is steadily winning converts in the corporate world. But much corporate practice still betrays the strong influence of accounting considerations and an unwillingness to believe what the market is saying. The prevalence of accounting-based management is the greatest challenge for the modern business school, and its greatest opportunity. The lessons of modern finance offer a great opportunity for managers to improve their service to shareholders. The MBAs who carry these lessons from the premier business schools into the next generation of senior management can be expected to provide great benefits for stockholders.