14th November, 2013
It is of no doubt that value created by the managment of the company benefits the shareholders but it is the society which is benefited at largebecause the quest for value by the management drives resources to the most efficient use and thus benefiting the society as a whole. However, even today there is not set principle or theory on how share prices are determined?
In the financial arena, there are two methods of valuation of shares: Accounting Model and Economic Model.
Accounting model is the conventional model of calculating share price using multiples of P/E and EPS, where share value is calculated by multiplying EPS and P/E Ratio. Although this method is simple and prvoides apparnt precision, it lacks practical approach as it assumes that PE never change but the multiple of P/E changes on account of multiple corporate activities like acquistions, change in accounting policies etc. , thus following this method is inefficient and unreliable.
Contrary to it, economic model of valuation of shares is a more reliable source of adjudging the true value of shares as the same is based on the method of discounting of free cash flows of the company. However, since a company takes forward both of its earnings as well as free cash flow it is important to judge whether capitalizing of earnings or discounting of cash flows reflects true share value. Thus, to study these effects, we have to look for the events that cause both the earnings and cash flows to depart from each other.
Earnings or Cash Generations:
While shifting from FIFO inventory to LIFO inventory, whic h leads t o lower profits because of high Cost of Goods Sold but a saving in taxation is achieved while shifting from FIFO to LIFO on account of lower profits. Academic researchers found that when the company switched to LIFO Inventory method, it saw an increase of 5% in its share price and also the percentage of price gain was in proportion to the present value of taxes saved. Thus, a first proof was collected that share prices are dictated by cash generations not book earnings.
Amortization of Goodwill:
When purchase method is used for acquistion, any excess price paid over fair value of seller’s assets is recognized as Goodwill, which will then be amortized for a period not exceeding 40 years. However , since amortization is a non-cash expense it is of no value in economic model although it will affect accounting method as it reduces earnings.
Further, in search of evidence if amortization of goodwill affects economic or accounting model, it was found by the researchers that investors were least interested in method of recording the acquistion i.e Pooling of Interest Method or Purchase Method and what actually matter was how much cash is paid out to consummate the acquistion transaction and not as how the transaction is recorded. Thus, here also it is proved that share value is determined by expected cash generations and not by reported earnings.
Effect of Dividends:
Apart from unreliability of earnings in determining share price, it was also found that even dividends do not affect the valuation of shares. Academic researchers admitted that even in the economic model, paying dividend is a managment failure to find enough attractive investment opportunities to use all available cash.
Although we have gathered evidence in support of economic model but still many companies and their senior management foresake truly economic decisions in support of earnings estimates. Thus, there is need to educate the senior management as how a stock market really works and why economic method of valuation is far more reliable and efficient.
Stewart, G. (1990). Market Myths. In Harper and Row, The quest for value: A guide to Senior Management (pp. 1-18). USA.