Cash Is King Ch.5 Review FIN 622 Yi-Heng,Chen April 16, 2007

Many executives believe that if they figure out a way to boost reported earnings, their stock prices will go up. This is not the case. The market is smart ; these executives are not so smart.

Valuation Methods Traditional Accounting Measurement Balance Sheet Income Statement Statement of Owners Equity Statement of Cash Flows New Paradigm Free Cash Flow Cost of Investing Return on Invested Capital

The evidence from the manner in which the market works suggests: Changes in value are linked more closely to changes in expectations than to absolute performance. Valuation levels are linked to return on invested capital and growth. The market sees through cosmetic earnings effects and focuses on underlying economic results. The market puts great weight on long-term results, not just short-term performance.

VALUE LINKED TO EXPECTATIONS Changes in value (measured by TRS) over short periods of time are more linked to performance compared with expectations than to actual and absolute performance. In 1997 Intel reported 19% earnings growth and stock declined 6.3% because of 23% forecast.

Relationship between TRS and Expected Performance

VALUE LINKED TO ROIC/GROWTH A company’s value at any given point in time is more linked to the actual and absolute performance – represented by expected sales levels, earnings growth, and return on invested capital.

VALUE LINKED TO ROIC/GROWTH Valuation levels are linked to return on invested capital and growth. Authors conducted a survey of 340 large companies Five year growth Five year average spread (ROIC vs. Opportunity Cost of Capital) Average Market/Book Value → Higher spread leads to higher market/book. → Higher levels of sales growth are associated with higher market/book, except for low or negative spread companies.

Relationship between Market Values, Spread, and Growth

Market-to-Book Regressions

More Regression Analysis for you Statisticians…

MARKET SEES THROUGH COSMETIC EARNINGS EFFECTS (CREATIVE ACCOUNTING) The market looks much deeper than reported earnings. It does not respond naively to pure accounting numbers. It is smarter than the managers who attempt trickery to show inflated earnings. Accounting methods in different countries

German Industrial Company - Hoechst Year German accounting (DM million) U.S accounting (DM million) Difference (percent) 19951,709(57)NM 19962,1141,324-37% 19971, %

Inventory Valuation Choice of accounting method affects both earnings and cash flow – in opposite directions. In periods of rising prices: LIFO inventory method results in lower earnings, lower income taxes, higher after-tax cash flow. FIFO - just the opposite.

Inventory Valuation (cont) Accounting model suggests that a switch from FIFO to LIFO should result in a lower share price. Some researchers in cash flow valuation methods have found that a switch from FIFO to LIFO results in a higher share price (due to increased cash flow).

Inventory Valuation (cont)

Mergers and Acquisitions Purchase: Price Paid – Book Value = Goodwill (amortized over 40 years) Pooling of Interests: Reported at Book Value with no amortization. Earnings are higher without amortization

Mergers and Acquisitions (cont)

MARKET FOCUSES ON LONG TERM The market puts great weight on long- term results, not just short-term performance. Internet Companies – valued very high even without earnings or products to sell. Dividends as percentage of stock price. Market reacts favorably to increases in investment Changes in Leverage

Present Value of Expected Dividends Dividends as a percentage of stock price – analysis shows that on average 9.2% of the total share value can be attributed to dividends expected in the following five years.

New R&D Projects Announced Managers might reduce spending on investment in order to increase stock value. This effect is short-term only. SEC economists have shown that the market reacts positively to companies announcements of new R&D projects.

Long-Term Investment Type of InvestmentSample Size Cumulative 2-day market adjusted return (percent) Capital Expenditures Product Strategies R&D Expenditures Joint Venture Formations Total Sample

Market values CASH, not earnings Exchange and Stock Swap Transactions EPS impact does not matter Change in Leverage matters Decrease in Leverage = negative share price reaction Leverage increasing = positive share price reaction.

Is the Stock Market Efficient? There is an on-going debate about whether the stock market is efficient and the implications for management behavior. Any inefficiencies that do exist are mostly small and short term. Summary : Managers who use the DCF approach to valuation, focusing on increasing long term free cash flow, ultimately will be reward by higher share prices.