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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

  • 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

  • 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

  • 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

  • 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 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

  • 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 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”

  • 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

  • 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 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”

  • The Big Bath

  • Vendor Financing

  • Pension Funds Gains

  • Timing of Revenue and Expense Recognition

F305 Intermediate Corporate Finance


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

  • 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!

  • 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

  • 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

  • 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

  • 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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