Market Myths

In Search of Value:The Accounting Model vs The Economic Model

Accounting Model: Sets share price according to EPS and P/E multiple.● Pros: Simple and precise● Cons: Lack of realism● Assumes P/E multiples never change.

o Changes in P/E from...

The Accounting Model vs The Economic Model

The Economic Model, 2 Factors:● Cash to be generated over the life of a business● Risk of the cash receipts● Intrinsic value is determined by discounting future Free

Cash Flow (FCF) back to a present value at a rate of return that reflects “cost of capital”

● FCF: Cash flow generated that is free (net) of the new capital invested for growth.

● Positive or negative FCF?

“Just Say No”

● RJR puffed up sales by “loading” cigarette inventories on its distributors.

● Purchased before semi-annual price increases● 18 billion excess cigarettes on dealers shelves● Discontinued practice: cut shipments 29% in the 3rd

quarter and 17% in the 4th quarter.● Accounting vs Economic Model Impact?

Research and Development

Is R&D an Expenditure or Expense?● An expense is a cost that has expired.● An expenditure is a payment or disbursement.

o An expenditure to eliminate a liability is not an expense.

● Why is R&D recorded as an expense?

Research and Development

● Like any capital expenditure that is expected to create an enduring value, R&D should be capitalized onto the balance sheet and then amortized against earnings over the period of projected payoff from successful R&D efforts.

● R&D is capitalized in stock market value, why is it written off as an immediate expense?

● R&D does not always create value, but it is expected to.

Research and Development

● Full cost versus successful efforts:o What if the R&D fails to pay off?

● Any company that writes off an unsuccessful investment will subsequently overstate the rate of return investors have realized.

● The market uses full cost accounting to judge rates of return.

Research and Development

● A company’s balance sheet can at best be a measure of capital - the amount of cash deposited by investors into the company.

● Whether such capital translates into value based on the economic model of discounted cash flow rate of return on that capital.

● Is the book we are reading an expense or an expenditure?

Earnings Per Share Do Not Count

Two companies:Company A: Earn $1 per share, 1000 shares outstanding. Sells at 20 times earningsCompany B: Earn $1 per share, 1000 shares outstanding. Sells at 10 times earnings

Earnings Per Share Do Not Count

● It does not matter who buys or sells, PE ratio will be the same

● EPS does not matter because an acquisition will affect the total quality of earnings

● A spin-off will not increase benefits to shareholdersFrom ‘Market Myths’, G. Bennett Stewart III, p. 40

The Problem With Earnings Growth

● Growth = Rate of Return x Investment Rate● Company A: Growth = 10%, but must reinvest all

earnings to sustainCompany B: Growth = 10%, but only needs to reinvest 80% of earnings to sustainB would warrant higher value because it earns 12.5% rate of return on capital

● Fast growth only adds value if it also results in a good return; if not, value is reduced

The Role of Lead Steers

● A small group of very wealthy investors (the lead steers) makes up the majority of stock trading. It helps to determine stock prices

● The rest of investors are “price takers”● To get information, just interview the lead steer, and not

the entire herd● However, the lead steers are also affected by economic

forces such as supply and demand

Dividends Do Not Matter

“In the economic model, paying dividends is an admission of failure - management’s failure - to find enough attractive investment opportunities to use all available cash.”

Investors should not worry about dividend yield and payout when picking stocks, but rather risk, diversification, taxes, and value.

Dividends should be paid either all at once or not paid at all. Dividends paid are “capital gains lost for sure.” (p.44)

The Myth of Market Myopia

The concept of market myopia was discussed by prof. Theodor C. Levitt which actually suggest that businesses

will do better in the end if they concentrate on meeting customers needs rather than on selling products.

In other words it meant companies focus on short term results rather than long term benefits.

The Myth of Market MyopiaMYOPIC STOCK MARKETDonald N. Frey CEO, Bell & Howell

● Investors expectation for simultaneously high dividend on stocks, high interest rates on bonds and rapid growth in the price of securities force managers to forgo many of their promising future ventures.

● Money Managers ignore the long term payoffs and instead focus on short term results. (Quarterly Results Pressure)

● They are forced to deliver exceptional results every quarter which should be rewarding for investors and should increase stock price.

The Myth of Market MyopiaResearch Proves it wrong

● Market Sophistication- Companies who aim for long run growth and profitability sell for highest P/E multiples. Otherwise if all market cared about was near term earnings, wouldn’t all companies sell for the same P/E Ratio?

● Research by SEC shows that Institutional investors own a far larger percentage of shares of R&D intensive companies than of mature blue chip stocks. Far from indicating shortsightedness and reveals patience and a positive appetite for long run payoffs.

Evidence on Market Myopia

Study done by McConnell/Muscarella provides evidence that the market is not myopic. It suggests that the market:

● Factors into stock prices a realistic estimate of the long run payoff from management’s current investment decisions;

● Is able to distinguish value adding from value neutral opportunities; and

● Does not care whether the accountants expense or capitalise value building outlays.(R&D)

Supply and Demand

● Misconceptions on the belief that share prices are set by a relationship between supply and demand, and that management can market its common stock as any other consumer product.

● This will only lead to raise volume not price.

● Bell South- Madison Avenue Approach.Increased trading volume but not in stock price, thereby benefitting brokers not shareholders.

Evidence on Supply and Demand

● Study shows strong evidence that share prices are determined by intrinsic value not by supply and demand.

● Price Decline was in response to some likely fundamental decline in the company’s prospective economic performance.

● Stock prices are set by the lead steers appraisal of intrinsic values, not supply and demand.

Conclusion

● EPS, earnings, and earnings growth are misleading in determining business performance

● Stock prices are set by “lead steers”, not all investors● The market is not myopic● Paying a dividend does not improve investors’ returns

over the long run● Managers must increase their knowledge on how the

stock market operates