F305 Intermediate Corporate Finance. Indiana University September 5, 2001. What truly drives stock prices: Earnings or Cash flows?. Accounting Model of Valuation Share price is set by capitalizing a company’s EPS. Sources: income statement and balance sheet. Economic Model of Valuation
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F305Intermediate Corporate Finance Indiana University September 5, 2001
What truly drives stock prices: Earnings or Cash flows? • Accounting Model of Valuation • Share price is set by capitalizing a company’s EPS. • Sources: income statement and balance sheet. • Economic Model of Valuation • Intrinsic value of the firm is determined by discounting its expected future “Free Cash Flow” back to a present value at cost of capital. • Sources: uses and sources of cash. • Will a negative FCF less desirable? • Short term FCF vs. FCF over the life of the firm.
Economic Model is Preferred • Accounting model assumes P/E ratios never change • They do due to acquisitions, divestitures, changes in financial structure and accounting policies. • Other evidence: • LIFO vs. FIFO • Empirical evidence: companies switching to LIFO experienced a 5% increase in price at announcement. • Companies using LIFO sell at a higher P/E ratio than FIFO firms. • Amortization of Goodwill • No consequence in the economic model • Affects earnings in the accounting model
Trouble with Earnings • Is R&D an expenditure or expense? • Deferred Taxes
EPS Do NOT Count • Example: Firm HI and firm LOW • HI has a high P/E ratio, LOW has a low P/E ratio • The two merge by exchanging shares • Regardless of who buys whom, the new company will be the same. But accounting EPS would suggest differently. • Multiples will climb to counter the dilution of EPS.
Troubles with Earnings Growth • Rapid earnings growth is no guarantee of a high P/E multiple. • Growth = Rate of Return × Investment Rate • Rate of Return • measures Quality of investments • Rate of Return = Cash flow / investment • Investment Rate: • measures Quantity of investments • Investment Rate = New capital investments / earnings. • Case: W.T. Grant
Dividends Do NOT Matter • Dividends mean that firm cannot find growth opportunities to invest the excess cash. • Investors can find better deals in the market as a whole. • Can get money back to investors by buying back stock instead of paying dividends. • Empirical evidence (Black and Sholes) • Firms that do not pay dividends are not perceived as more risky than those that do. • Investors worry about risk, diversification, taxes and value, not dividend.
Manipulating Financial Statements • On March 20, 2000, MicroStrategy announced that it is restating its 1998 and 1999 full year results. • Its 1999 full year result is a loss of 43 cents to 51 cents per share, rather than a previously expected profit of 15 cents per share. • Reduced its reported 1999 revenue of $205.3 million to between about $150 million and $155 million. • The company’s price dropped 59% immediately, and later to 94% from its all time high of $333 on March 10, 2000. • On September 3, 2001, the company is traded at $2.47. • What did MicroStrategy do? • Timing of revenue recognition. • Did the market anticipate that?
Who Set Market Price? • Relative handful of prominent investors account for the majority of trades. • What are they looking for (ex. SAM): • Stocks at discount from what they appraise market value to be • FCF • Liquidation value of firm • Investigate economic environment of the firm
Is the Market Shortsighted? • Does the market put too much emphasis on short term growth and performance? • If so, what is the implication? • Institutional investors hold more R&D intensive companies. • Market fluctuates might be due to the change of intrinsic values. • The market may have different view about a firm’s investments.
Supply and Demand • Will supply and demand affect the stock price? • The payoff of a stock can always be duplicated by using other financial instruments. • Attributes an investor wants such as • Income • Risk • Potential for capital appreciation • Exposure to the business cycle can be obtained by selecting shares from a wide variety of easily substituted companies.
Key Point • Earnings, EPS, and earning growth are misleading measure of corporate performance. • Earnings can be diminished or manipulated. • EPS measures only the quantity, not the quality of earnings. • Achieving an adequate rate of return is far more important tan growing rapidly. • Financial markets can have different predictions about a capital project. • Paying dividends does not enhance the total return • Stimulating investors’ demand for share will increase only share volume, not share price. • Sophisticated investors care about the generation of cash and the risks taken over the entire life of the business.