Market Myths Andrew Brake Zhe Chen Ruodong Sun Group 2 Finance 680 G. Bennett Stewart III, from Corporate Finance

How Is Corporate Value Measured? (1) What is more important in determining share value: reported earnings (accounting method) or free cash flow (economic method)? (2) How do accounting practices obscure a company’s true value? (3) Do earnings per share matter? (4) Is earnings growth a good indicator of company performance? (5) How do “lead steers” help determine share price? (6) Do dividends matter in determining share price? (7) Are investors shortsighted regarding a company’s long term prospects? (8) Is share price affected by supply and demand?

Accounting Model (Earnings) vs. Economic Model (FCF) Accounting Model Multiply company’s earnings per share (EPS) by appropriate P/E ratio Pros: Ease of use, apparent accuracy Cons: Not realistic Evidence suggests that earnings are not a good indicator of corporate value Economic Model Discount projected future free cash flow (FCF) to present value at rate that reveals cost of capital Free cash flow: cash flow that remains after capital investment Cost of capital: Investors’ required rate of return for taking on risk +FCF and -FCF can both add to firm value

Earnings vs. Free Cash Flow Accounting practices impact share price Switching to LIFO from FIFO leads to average of 5% share price increase even though it lowers reported earnings  Saves on taxes ⇒ frees up more cash In acquisitions, the amount of cash paid relative to future expected cash flow matters, not actual acquisition method Purchase method: amortization of goodwill reduces reported earnings Pooling of interests: adds book value of seller’s assets to buyer’s books Some sellers want only cash or buyers reject issuing equity ⇒ pooling option eliminated Purchase method now only choice, but buyers fear reducing reported earnings and therefore walk away from good deals

Accounting Practices and Corporate Value Incorrect assumptions about recording R&D obscure true corporate value Expenditure: Assumes R&D will have long-lasting benefits; amortized against anticipated future payoff Expense: Assumes R&D benefits run out within reporting period; considered as immediate cost Misuse of successful efforts accounting after writing off a bad investment can lead to overstating rate of return (RoR) Economic model of accounting takes certain write-offs from income statement and puts them on balance sheet  Ensures that RoR improves only if cash flows improve from write-off Accounting statements should move from lenders’ perspective to shareholders’ perspective

Earnings Per Share and Corporate Value Earnings per share (EPS) doesn’t actually matter Company with high P/E multiple buys company with low P/E multiple: Buyer’s EPS increases - considered good deal Reversed situation: Buyer’s EPS decreases - considered bad deal Merged company is still the same, regardless of transaction direction Company’s P/E multiple will rise or fall after acquisition based on quality of earnings Economic method considers exchange of value relevant, not exchange of earnings (accounting method)

Earnings Growth and Company Performance Earnings growth does not accurately show company performance because companies achieve growth different ways Key equation: Growth = Rate of Return x Investment Rate (quality of investments x quantity of investments) Fast growth can be deceptive sign of added value Acceptable rate of return is needed to create value

Lead Steers and Share Valuation Knowledgeable elite traders (“lead steers”) play large role in setting share prices  Responsible for majority of trades on Wall Street  Prices set “at the margin” Impact of ordinary investors greatly overstated Price setters vs. price takers Lead steers “think like businessmen, not accountants”

Dividends and Company Valuation Dividends do not matter in determining company’s value Economic model: Paying dividends admits failure to find profitable investments Do investors actually want dividends? Contradicts popular view of rising dividends as signal of company health Research by Black and Scholes: Comparably risky dividend and nondividend paying shares had same overall rate of return Advice to investors: Ignore dividends; focus on risk, diversification, taxes, and value Advice to managers: Organize dividend policy to meet company’s own investment needs

Myth of Market Myopia Popular view: High trading volume reflects demand for profitable short term results, which come at expense of long term prospects Reality: Market takes long view perspective when determining stock prices  Institutional investors own larger percentage of R&D intensive companies than of more established blue chip stocks High trading volume is result of low cost trades and constant response to new information Rise and fall in share prices can reflect investor confidence in long term projects

Supply & Demand and Intrinsic Value Supply-Demand Enthusiast The greater the number of shares unleashed on the market, presumably the greater would be the discount required to induce investors to take up the shares. The price decline would likely be temporary. After the surplus supply of shares is absorbed into the market, a more normal share value should return. It plays a role in determining shares but only in the aggregate. Intrinsic Value Share prices are determined by intrinsic values not by an interaction between supply and demand. (Myron Scholes) The quality of information rather than the quantity of shares traded is what determines the depth of the price discount. Stock prices are set by the lead steers’ appraisal of intrinsic values (that is, prospect for cash generation and risk)