Market myths
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Market Myths. What truly drives stock prices: Earnings or Cash Flow? The Accounting Model of Valuation is based on earnings EPS times a P/E multiple = Stock Price The Economic Model of Valuation Intrinsic value is determined by discounting the future FCF

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Market Myths

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Market myths

Market Myths

  • What truly drives stock prices: Earnings or Cash Flow?

    • The Accounting Model of Valuation is based on earnings

      • EPS times a P/E multiple = Stock Price

    • The Economic Model of Valuation

      • Intrinsic value is determined by discounting the future FCF

      • Discounted at a cost of capital that reflects risk

      • Separates the investment and financing decisions

      • It is possible to have negative FCF in the short-term

      • Valuation is impacted by high growth, but “good” growth is influenced by:

        • The investment rate: the quantity of investments

        • The rate or return: the quality of investments

      • According to Market Myths, Dividends do not matter!

F305 Intermediate Corporate Finance


Evidence in favor of the economic model

Evidence in Favor of the Economic Model

  • Companies switching to LIFO experience a 5% increase in price at the time of announcement

  • The stock prices of companies that make acquisitions through asset purchases are not penalized vs. companies that perform a “Pooling”

F305 Intermediate Corporate Finance


Why earnings eps and earnings growth are misleading measures of performance

Why Earnings, EPS and Earnings Growth are Misleading Measures of Performance

  • If valuation is based on discounted free cash flow, why is there such as strong reaction to earnings pronouncements?

    • Earnings and cash flows, while distinct and different, are nonetheless closely linked

    • Accounting statements provide historical perspective

    • They serve as the starting point for financial analysis

    • Most investors pay close attention to company financial pronouncements!

F305 Intermediate Corporate Finance


Pro forma financial reporting

Pro-Forma Financial Reporting

  • Companies provide pro-forma results in addition to those filed with regulatory agencies

    • Often strip out one time charges and expenses

      • Restructurings

      • Stock-option expenses

      • Write-downs for impairment issue

  • Motorola

    • 15 consecutive quarters with a special item reported!

    • Since 1999, adjustments total $11.3 billion

    • Do these reflect the normal course of business or not?

F305 Intermediate Corporate Finance


Pro forma financial reporting1

Pro-Forma Financial Reporting

  • Other pro-forma “tricks”

    • Pension fund accounting

    • Loans to customers

    • The “big bath”

      This just names a few of the techniques used to potentially mislead investors!

F305 Intermediate Corporate Finance


Accounting for stock options

Accounting for Stock Options

  • The impact of options are currently excluded by most companies

  • How are options currently accounted for?

    • The impact of options appears in a footnote to the financials

    • Profits to employees are taxed as ordinary income

      • Exception for incentive stock options if the stock is held for one year after the option is exercised. Most options are not this type

    • If taxed as ordinary income, they provide a deduction for the company as compensation expense

    • Compensation is calculated by subtracting the exercise price from the market price of the options on the first date on which are known both

      • the number of shares the employee is entitled to receive

      • the option or purchase price

F305 Intermediate Corporate Finance


Accounting for stock options1

Accounting for Stock Options

  • But what happens is subsequently the stock price drops?

  • FASB proposal in 1993 was to calculate the value of the options (perhaps using Black-Scholes) and expense them over the vesting period. This was rejected and the disclosure was relegated to the footnotes

  • Value of the options depend on the stock price, the option strike price and time to maturity (and other B-S variables)

F305 Intermediate Corporate Finance


Dilution the other expense

Dilution: The “Other Expense”

  • Fully diluted EPS reflects only those stock options that are “in the money”

    • Could exclude many options!

F305 Intermediate Corporate Finance


Inconsistent reporting challenges in comparing statements

Inconsistent Reporting – Challenges in Comparing Statements

  • Winn-Dixie and Boeing deduct the estimated value of employee stock options from income each reporting period

  • If Starbucks did the same, net income would have been reduced in 2001 by 30%

  • At Cisco, net income would have been reduced by 42% YTD through July

  • UPDATE!

    • Many companies this summer decided to start expensing options in light of accounting scandals including, Cinergy, Bank One, GM, Proctor and Gamble, Coke, GE and Amazon

    • These announcements and the expensing of the options did not have a negative impact of the per share price!

    • Do investors already take these expenses into account?

F305 Intermediate Corporate Finance


Inconsistent reporting challenges in comparing statements1

Inconsistent Reporting – Challenges in Comparing Statements

  • K-mart and Target call the year ending 1/31/01 2000. Wal-Mart calls it 2001

  • Amazon excludes net interest expense from pro-forma results. Most companies do not

  • Amazon actually reported two different pro-forma results for the first quarter of 2001. A loss of $49M and a loss of $76M. According to GAAP, their loss was $234M

F305 Intermediate Corporate Finance


Four tricks of the trade

Four “Tricks of the Trade”

  • The Big Bath

  • Vendor Financing

  • Pension Funds Gains

  • Timing of Revenue and Expense Recognition

F305 Intermediate Corporate Finance


The big bath

The Big Bath

  • Make a bad year worse, in order to improve the future

    • On April 16, 2001 Cisco announces a $1.2B charge for laying off workers, closing buildings and re-valuing Goodwill

    • At the same time, announce a $2.5B inventory write-off, primarily raw materials

  • Announce large write-offs just prior to a merger to prop up post-acquisition results

F305 Intermediate Corporate Finance


Vendor financing

Vendor Financing

  • Motorola

    • On Feb 3, 2000, Motorola announced a $1.5B order to Telsim, Turkey’s #2 Wireless Telephone carrier

    • In SEC filings made March 30, they disclosed loans to the same company totaling $1.7B

    • In October 2001, Motorola reported a 3rd quarter pro-forma loss of $153M

    • After including charges for impaired investments, cost reduction activities and increasing reserves for the Turkish company Telsim, the company reported a loss of $1.4B!

F305 Intermediate Corporate Finance


Vendor financing motorola update

Vendor Financing - Motorola Update!

  • Motorola not alone - Nokia did basically the same transactions for $700M

  • Motorola (and Nokia) are now suing in federal court in Manhattan

    • “Every indication is the the defendants, behind a façade of legitimacy, engaged repeated acts of fraud and chicanery, and thereby perpetrated and continue to perpetrate a rather massive swindle!”

    • Whatever happened to “due diligence”??

  • “I doubt they are going to recover any meaningful amount of money”

    • Woytek Uzdelewicz, Bear Stearns telecom analyst

F305 Intermediate Corporate Finance


Pension fund gains

Pension Fund Gains

  • In 2000, 1.7% of pre-tax income for IBM was the result of changing the assumption for their expected rate of return on pension fund investments from 9.5% to 10%

  • General Electric reported that 9% of its earnings in 2000 were from Pension plan profits (that is 2.5 times more profit than their appliance division reported!)

  • According to Goldman Sachs, 35 companies in the S&P 500 reportedly received 10% or more of their earnings from Pension funds

  • Companies are raising expected returns from investment plan investments at the very time when investment returns in general are falling

  • According to Warren Buffet, “I think anyone choosing not to lower assumptions is risking litigation for misleading investors”

F305 Intermediate Corporate Finance


The timing of revenue and expense recognition

The Timing of Revenue and Expense Recognition

  • Change asset lives to reduce the depreciation deduction

  • Readers Digest Association Inc. revised their bad debt assumptions to the tune of $.16 per share in December 2000

  • Verizon Wireless Inc. amortizes the costs of wireless licenses over the course of 40 years because they are renewable – but what about technological obsolescence

  • Computer Associates International reported EPS of $.42/share in pro-forma statements, but a loss of $.59/share in its GAAP statements based on their treatment of terms in their software sales contracts

F305 Intermediate Corporate Finance


The pay off the case of aol

The Pay-off: The case of AOL

  • AOL deferred the marketing expense of sending out millions of computer disks to potential customers

  • By capitalizing these costs instead of expensing them, AOL boosted profits

  • AOL pays a small fine and re-states prior years earnings in May 2000

  • AOL is able to merge with Time Warner to create AOL Time Warner in January 2002

  • AOL Time Warner announces largest write-off ever in January 2002

F305 Intermediate Corporate Finance


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