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  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,  On September 3, 2001, the company is traded at $2.47. What did MicroStrategy do?  Timing of revenue recognition. Did the market anticipate that?

Manipulating Financial Statements

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.