Chapter 3 on Valuation and Reporting in Organization
- 1. Chapter 3: Do Fundamentals Really Drive the Stock Market?
- 2. Table of Content Shareholder Value Driven By Return And Growth Market Focuses On Long Term Rather Than Short Term Markets See Fundamentals Behind Accounting Information Significant Deviations From Intrinsic Value Are Relatively Rare And Short-lived Implications Of Market (In)efficiency For Corporate Managers 2
- 3. Fundamentals or emotions? Return on capital, growth, and free cash flows drive value in the capital markets: Companies with higher returns and higher are valued more highly in the stock market; To value stocks, markets primarily focus on the long-term and not short-term economic fundamentals Stock markets are capable of seeing the economic fundamentals behind accounting information Stock market valuations correctly reflect underlying economic fundamentals, even when individual investors do not invest on the basis of the fundamentals Market-wide price deviations are short-lived 3
- 4. 1. SHAREHOLDER VALUE DRIVEN BY RETURN AND GROWTH Key Ideas: Valuation Levels Driven by Long-Term ROIC and Growth Changes in Expectations Drive Total Returns to Shareholders 4
- 5. 1. SHAREHOLDER VALUE DRIVEN BY RETURN AND GROWTH 5
- 6. 1. SHAREHOLDER VALUE DRIVEN BY RETURN AND GROWTH 6
- 7. 1. SHAREHOLDER VALUE DRIVEN BY RETURN AND GROWTH 7
- 8. 1. SHAREHOLDER VALUE DRIVEN BY RETURN AND GROWTH 8
- 9. 1. SHAREHOLDER VALUE DRIVEN BY RETURN AND GROWTH 9
- 10. 2. MARKET FOCUSES ON LONG TERM RATHER THAN SHORT TERM 10
- 11. 2. MARKET FOCUSES ON LONG TERM RATHER THAN SHORT TERM 11
- 12. 2. MARKET FOCUSES ON LONG TERM RATHER THAN SHORT TERM 12
- 13. 2. MARKET FOCUSES ON LONG TERM RATHER THAN SHORT TERM Research confirms the long-term view of stock markets: Stock markets reward R&D and advertising initiatives; Announcements of capital expenditure increases and strategic investments usually boost share prices; Stock markets generally react positively to write-offs of bad investments 13
- 14. 3. MARKETS SEE FUNDAMENTALS BEHIND ACCOUNTING INFORMATION Key Ideas: Different Accounting Standards Do Not Lead to Different Values Treatment of Goodwill Does Not Affect Share Price Accounting for Employee and Management Stock Options Is Irrelevant for Market Value LIFO/FIFO Inventory Reporting Does Not Influence Share Prices (But the Tax Impact Does) 14
- 15. 3. MARKETS SEE FUNDAMENTALS BEHIND ACCOUNTING INFORMATION 15
- 16. 3. MARKETS SEE FUNDAMENTALS BEHIND ACCOUNTING INFORMATION 16
- 17. 3. MARKETS SEE FUNDAMENTALS BEHIND ACCOUNTING INFORMATION 17
- 18. 3. MARKETS SEE FUNDAMENTALS BEHIND ACCOUNTING INFORMATION 18
- 19. 3. MARKETS SEE FUNDAMENTALS BEHIND ACCOUNTING INFORMATION 19
- 20. 4. SIGNIFICANT DEVIATIONS FROM INTRINSIC VALUE ARE RELATIVELY RARE AND SHORT-LIVED 4.1 Key Conditions for Market Deviations Markets fail to reflect economic fundamentals under three conditions: Irrational investor behavior Systematic patterns of behavior across different investors Limits to arbitrage in financial markets 20
- 21. 4. SIGNIFICANT DEVIATIONS FROM INTRINSIC VALUE ARE RELATIVELY RARE AND SHORT-LIVED Key Ideas: Key Conditions for Market Deviations Market Overreaction and Underreaction, Reversal and Momentum Persistent Mispricing in Carve-Outs and Dual-Listed Companies Markets and Fundamentals: The Bubble of the 1990s Fundamentals Prevail 21
- 22. 4. SIGNIFICANT DEVIATIONS FROM INTRINSIC VALUE ARE RELATIVELY RARE AND SHORT-LIVED 4.1 Market Overreaction and Underreaction, Reversal and Momentum Two well-known patterns of price deviations: short-term momentum long-term reversal in share prices Explanations: investor overreaction systematic underreaction 22
- 23. 4. SIGNIFICANT DEVIATIONS FROM INTRINSIC VALUE ARE RELATIVELY RARE AND SHORT-LIVED 23
- 24. 4. SIGNIFICANT DEVIATIONS FROM INTRINSIC VALUE ARE RELATIVELY RARE AND SHORT-LIVED 24
- 25. 4. SIGNIFICANT DEVIATIONS FROM INTRINSIC VALUE ARE RELATIVELY RARE AND SHORT-LIVED 25
- 26. 4. SIGNIFICANT DEVIATIONS FROM INTRINSIC VALUE ARE RELATIVELY RARE AND SHORT-LIVED Three important conclusions: stock markets in the United States and the United Kingdom have been fairly priced and have oscillated around their intrinsic price- to-earnings ratios late 1970s and late 1990s did indeed produce significant deviations from intrinsic value when such deviations occurred, the stock market corrected itself within a few years to its intrinsic valuation level market valuations return to values justified by economic fundamentals. 26
- 27. 4. SIGNIFICANT DEVIATIONS FROM INTRINSIC VALUE ARE RELATIVELY RARE AND SHORT-LIVED 27
- 28. 5. IMPLICATIONS OF MARKET (IN)EFFICIENCY FOR CORPORATE MANAGERS How corporate managers can benefit from intrinsic value deviations by better timing the implementation of strategic decisions? Issuing additional share capital at times when the stock market is attaching too high a value to the company’s shares relative to intrinsic value Repurchasing company shares when the stock market underprices relative to the intrinsic value Paying for acquisitions with shares instead of cash when the stock market overprices the shares relative to intrinsic value Divesting particular businesses at times when trading and transaction multiples in that sector are higher than can be justified by underlying fundamentals …BUT… 28
- 29. 5. IMPLICATIONS OF MARKET (IN)EFFICIENCY FOR CORPORATE MANAGERS Important to note: Do NOT base your decisions exclusively on a perceived difference between market value and intrinsic value Be critical of analyses claiming to find such market deviations for their company’s shares 29
- 30. REVIEW QUESTION Many corporate executives focus on NI, EPS, ROI, dividends, and growth rates. In doing so, these executives attempt to manage balance sheet and income statement accounts in order to meet analysts’ expectations. Is a manager able to successfully manage these accounts to protect stock price and value? 30
- 31. Questions? Chapter 2. Fundamental Principles of Value Creation 31