FREE online courses on Financial Management and Creating Value - Chapter 2
- Problems with Stock Price Valuations
Although it is easy to refer back to stock prices as an
indicator of value, the truth is that stock prices may not accurately reflect
the value of a company because:
- Stock prices can be influenced by market forces,
such as general economic conditions, Federal Reserve policies, expectations of
inflation, etc. There is a broader set of dynamics that goes into establishing
the price of a stock. Stock prices do not move solely on the value of the
company.
- Stock prices fail to reflect hidden values within
a company. This is evident when a company decides to do a spin off. Even a
stock split can generate higher values.Â
Another problem we face with measuring values through stock
prices is that we do not want to hold managers responsible for things they
cannot control. It is important to use measurements of value that are within the
control of management. If we were to hold managers responsible for the stock
price of their company, they may tend to engage in programs that manipulate
stock prices. For example, it is not uncommon to see a new Chief Executive
Officer announce a cost cutting program to boost earnings. Stock prices go up
and management gets the illusion that re-engineering programs are a good source
of value-creation. The truth is that over the long run, reorganizations such as
slashing payrolls will not provide long-term sustainable value. Anyone can cut
costs by reducing payrolls.
A better approach to measuring value is needed. Can we fall
back on accounting forms of measurement, such as Return on Assets, Return on
Gross Investments, or Earnings Before Interest Taxes Depreciation Amortization
(EBITDA)? The answer is no because value-based metrics must meet two very
important test:
1.
They must focus on cash flows and not accounting
derived earnings since this is how we calculate value.
2.
They must recognize all cost associated with the
capital that we have invested; i.e. assets carry a cost.
This leads us to the next step in how we create value through
financial management - measuring how much value has been created or destroyed.
