Market Myths

1. Market Myths By Senlei Wang ZhiChen Xiang Guo Qianhao Wei Qizhen Shao

2. Introduction • As we know, the management’s most important job is to create value and wealth of the shareholders. • However, it is difficultto pursuit value if we do not understand how share price are really set in the stock market. • Many senior executives and board members believe the stock prices are determined by some complex combination of: • Earning • Growth • Return • Book value • Cash flow dividends • The demand for their shares

3. Introduction • The answer to what is the investors really want is significant for: • Making business strategy, • Acquisitions and divestitures, • Choosing accounting methods, • Building financial structure, • Creating dividend policy, • Building investor relation, • Making a bonus plan that is most important of all. • Moreover, with the competition for capital growing ever more hostile and global, the cost of confusing about this question is rising. • Next, we will find out “What is the engine that drives share prices”.

4. In Search of Value: The Accounting Model VS. The Economic Model • Right away there are two competing answers: • The traditional Accounting Model of Value • The Economic Model of Value • The Accounting Model of Value • Setting share price by capitalizing a company’s EPS at an appropriate P/E. • For example: A company typically sells ten times earnings, and EPS is $1.00, model would predict a $10.00 share price. • Advantages: • Simply • Apparent precision.

5. In Search of Value: The Accounting Model VS. The Economic Model • Disadvantages: • Utter lack of realism. • It assumes that the P/E multiple never change, in fact it changes all the time in the events like: acquisitions and divestitures, changes in financial structures and accounting policies, and emerging new investment opportunities. • That P/E multiple adjust to changes in the “quality” of a company’s earnings makes EPS a very unreliable measure of value.

6. In Search of Value: The Accounting Model VS. The Economic Model • The Economic Model of Value • Setting share prices by smart investors with 2 things in mind: • The cash generated over the life of a business. • The risk of cash receipts. • In other word, this model states that a company’s intrinsic market value is determined by discounting its expected future “Free Cash Flow (FCF) back to a present value at a rate that reflects its “costs of capital”.

7. In Search of Value: The Accounting Model VS. The Economic Model • Accounting model relies on two distinct financial statements: • Income statement. • Balance sheet. • Economic model use only: • Sources. • Cash.

8. In Search of Value: The Accounting Model VS. The Economic Model • When a company switching from FIFO (First In First Out) to LIFO (Last In First Out) in times of rising prices can decrease its reported earnings because most costly inventory is expensed first, but increases cash because it saves taxes. • However, share prices are dictated by cash generation, not by reported book earnings. Therefore, earnings can be misleading and should be abandoned in decision making.

9. More Troubles with Earning • Is R&D an Expenditure or Expense? • R&D is important tolong-term development. • Even if the R&D fails to pay off, outlays should not be immediately expensed. • Reason: Full-cost accounting is the only proper way to assess a company’s rate of return. • With full-cost accounting, an company capitalizes all drilling outlays onto its balance sheet and then amortizes them over the lives of the successful wells. • Key concept: Any company that writes off unsuccessful investment will subsequently overstate the rate of return realized by investors. Such overstatement can lead to overinvesting in businesses that really are not profitable

10. Earnings per share do not count EPS does not matter because, in the wake of an acquisition, a company’s P/E multiple will change to reflect a deterioration or improvement in the overall quality of its earnings. • two companies each currently earn $1.00 a share and have 1,000 shares outstanding, and that one firm sells for 20 times earnings while the other sells at 10 times its earnings • when Hi buys Lo, EPS increases to $1.33 and when Lo buys Hi, EPS falls to $0.66. Preoccupied with EPS • observe that no matter which firm buys and which sells, the combined company will have a P/E multiple of 15 (the consolidated value of $30,000 divided by the consolidated earnings of $2,000). Hi’s 20 P/E must fall, and Lo’s 10 P/E must rise.

11. The problem with earning growth • Earnings growth also is a misleading indicator of performance, It is determined by: quality of investment times quantity of investment. • Growth = rate of return * investment rateConsider: Two companies have same earnings, but one must invest more capital to sustain same growth.Suppose X and Y are growing earnings at 20%, but X must invest all of its earnings to grow at that rate, whereas Y needs to invest only 80% to keep pace. • In this example, Y provides higher value because it earns 25% rate of return, while X returns just 20%.Financial cosmetics are widely available to gloss over a company's true performance.Key concept: Rate of return is the only measure that allows Y to be reliably distinguished from X

12. THE ROLE OF LEAD STEERS • “LEAD STEERS”----- investors who truly set stock prices: they think like businessmen, not like accountants. • to determine what the free cash flow is and can be in the coming business cycle under normalized conditions. Then buy the company at a very reasonable multiple of that free cash flow. • take sales in the marketplace, arm's- length transactions between competent businessmen, and compare what they will pay for businesses versus the market value of the company we are looking at. • simply add up all the assets on the balance sheet, subtracting all the liabilities, and adjust for things like understated inventories or real estate • talk with management, suppliers, competitors. reach most of our conclusions by looking at the numbers and analyzing them

13. Dividends do not matter • Pay dividends is an admission of failure • Corporation: failure to find enough attractive investment opportunities to use all available cash. less money available to fund growth unnecessary financings, taxes

14. Dividends do not matter • Investor: can create their own dividend Sell or borrow against shares Add bonds and preferred stocks Make the residual capital gain that much riskier Will not penalize the share prices

15. The Evidence on Dividends • Study in Journal of Financial Economics in 1974. • Whether the total returns achieved during the period 1936 to 1966 from 25 carefully–constructed portfolios depended upon the dividend yield or dividend payout ratios of the underlying stocks. • Return to investors was explained by the level of risk, and was not at all affected by how the return was divided between dividends and capital gains. Do not formulate dividend policy to influence shareholders’ returns. Set dividend policy in company’s investment needs and financing options.

16. The myth of market myopia • The pressure force the manager to ignore the long-term payoffs from farsighted business decisions and instead focus only on near term results. • The real reason why the market rises or falls is simply that the lead steers decide that intrinsic value has changed. When this happens, trading volume may surge as investors adjust their portfolios to accommodate a new market value.

17. The evidence on market myopia • The McConnell study provide unforgettable evidence that, far from being myopic, the market: • Factors into stock prices a realistic estimate of the long-run profits from management’s current investment decisions. • Is able to distinguish value-adding from value-neutral opportunities. • Does not care whether the accountants expense or capitalize value-building outlays.

18. SUPPLY AND DEMAND • Misconceptions: stock price is depressed because of insufficient trading activity. • If number of shares outstanding is fixed, will increased demand by frequent advertising increase share price? NO, because supply is not fixed, and it is perfectly flexible. • Flexibility in demand makes trading volume an unimportant determinant. • efforts to promote company's appeal to investors increase trading volume, but not stock price. • stock prices are set by appraisal of intrinsic values (i.e. the prospect of cash generation and risk), not supply and demand

19. The evidence on Supply and Demand • Scholes’s research offers convincing and reassuring evidence that stock prices are set by the lead steers’ appraisal of intrinsic values, not supply and demand. • There are two important implications of Scholes’ research. • First, the goal of investor relations should revise expectations, instead stimulate demand. • Second, the price decline associated with raising new equity capital can be mitigated through a clear program of financial communication and by raising equity through a pre-announced sequence of small issues.

20. Conclusion • Earnings, EPS, and earnings growth are misleading measures of corporate performance. • EPS at best measures only the "quantity" of earnings, but the "quality" of earnings reflected in P/E multiple. • Rapid earnings growth can be produced by dumping capital into projects without standard. Earning an adequate rate of return is far more important than growing rapidly! • Senior managers and board of directors must be well educated about how stock market really works and their compensation schemes must be adjusted accordingly