.This episode illustrates that valuation benchmarks are valid only aslong as underlying economic and financial conditions do not change.The chronic postwar inflation, resulting from a switch to a paper moneystandard, changed forever the way investors judged the investmentmerits of stocks and bonds. Stocks were claims on real assets whoseprices rose with inflation, while bonds were not. Those investors whoclung to the old ways of valuing equity never participated in the greatest bull market for stocks in history.
VALUATION OF CASH FLOWS FROM STOCKSThe fundamental sources of stock valuation derive from the earningsand dividends of firms. In contrast to a work of art—which can bebought both for an investment and for its viewing pleasure—stockshave value only because of the cash flows that current investors receiveor the appreciation caused by cash flows that future investors hope to receive. These cash flows may come from the payment of dividends out ofearnings or from cash distributions resulting from the sale of the firm’s3
“In the Markets,” BusinessWeek, September 13, 1958, p. 91.“The Many Aspects of Yields,” Financial Analysts Journal, vol. 18, no. 2 (March–April 1962), pp.49–62.4
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assets. One can estimate the investment value of shares by forecastingand valuing these expected cash flows.5More generally, the value of any asset—stock, bond, real estate, orany other property—is determined by the discounted value of all expected future cash flows. Future cash flows are discounted because cashreceived in the future is not worth as much as cash received in the present. The reasons for discounting are (1) the innate time preferences of mostindividuals to enjoy their consumption today rather than wait for tomorrow; (2) productivity, which allows funds invested today to yield ahigher return tomorrow; and (3) inflation, which reduces the future purchasing power of cash received in the future. A fourth reason, which applies primarily to the cash flows from risky assets such as equities, is theuncertainty associated with the magnitude of future cash flows.
Sources of Shareholder ValueFor the stockholder, earnings are the source of future cash flows. Earnings, profits, and net incomes are the cash flows that remain after thecosts of production are subtracted from the sales revenues of the firm.The costs of production include labor and material costs, interest ondebt, corporate taxes, and allowances for depreciation.Firms can create value for shareholders by using their earnings in anumber of ways. The first and historically the most important is this one:• Payment of cash dividendsEarnings that are not used for dividends are called retained earnings.Retained earnings can be used to create value in the following ways:• Retirement of debt• Investment in securities or other assets or acquisition of otherfirms• Repurchase of the firm’s own shares (which is known as a buyback)• Investment in capital projects designed to increase future profitsIf a firm retires its debt, it reduces its interest expense and therefore increases the cash flow available to shareholders. If a firm buys assets, the income from these assets is available to pay future dividends5
There might be some psychic value to holding a controlling interest in a firm. In that case, theowner values the stock more than minority shareholders value it.
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or otherwise increase value. If a firm repurchases its shares, it reducesthe number of shares outstanding and thus increases future per shareearnings. Finally, retained earnings can be used to expand the capitalof the firm in order generate higher future revenues and/or reducecosts.Some people believe that shareholders value cash dividends themost, and that assertion is probably true in a tax-free world. But from atax standpoint, share repurchases are superior to dividends. As discussed in Chapter 5, share repurchases generate capital gains whose taxcan be deferred until the shares are sold. Recently an increasing numberof firms have been engaging in share repurchases. Nevertheless, thecommitment to pay a cash dividend often focuses management on delivering profits to shareholders and reduces the probability that earningswill be spent in a less productive way.Others might argue that debt repayment lowers shareholder valuebecause the interest saved on the debt retired is generally less than therate of return earned on equity capital. They might also claim that by retiring debt, they lose the ability to deduct the interest paid as an expense(the interest tax shield).6 But debt entails a fixed commitment that mustbe met in good or bad times, and, as such, the use of debt increases thevolatility of earnings. Reducing debt therefore lowers the volatility of future earnings and may not diminish shareholder value.7Some investors claim the investment of earnings is an importantsource of value. But this is not always the case. If retained earnings arereinvested profitably, value will surely be created. But retained earnings, especially if they are accumulated in liquid investments, mighttempt managers to overbid to acquire other firms or to spend thesefunds on perquisites and other activities that do not increase the valueto shareholders. Therefore, the market often views the buildup of cashreserves and marketable securities with suspicion and often discountstheir value.If the fear of misusing retained earnings is particularly strong, it ispossible that the market will value the firm at less than the value of its6Whether debt is a valuable tax shield depends on whether interest rates are bid up enough to offset that shield. See Merton H. Miller, “Debt and Taxes,” Papers and Proceedings of the Thirty-FifthAnnual Meeting of the American Finance Association, Atlantic City, N.J., September 16–18, 1977,Journal of Finance, vol. 32, no. 2 (May 1977), pp. 261–275.7Meeting interest payments may also be a good discipline for management and reduce the tendency to waste excess profits. See Michael Jensen, “The Takeover Controversy: Analysis and Evidence,” in John Coffee, Louis Lowenstein, and Susan Rose-Ackerman, eds., Takeovers and Contests forCorporate Control, New York: Oxford University Press, 1987.
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reserves. Great investors, such as Benjamin Graham, made some of theirmost profitable trades by purchasing shares in such companies and thenconvincing management (sometimes tactfully, sometimes with a threatof takeover) to disgorge its liquid assets.8One might question why management would not employ assets ina way to maximize shareholder value since managers often hold a largeequity stake in the firm. The reason is that a conflict often exists betweenthe goal of the shareholders, which is solely to increase the return ontheir shares, and the goals of management, which may include prestige,control of markets, and other objectives. Economists recognize the conflicts between the goals of managers and shareholders as agency costs,and these costs are inherent in every corporate structure where ownership is separated from management. Payment of cash dividends or committed share repurchases often lowers management’s temptation topursue goals that do not maximize shareholder value.Finally, capital expenditures are certainly necessary in a growingfirm, yet many studies show that firms often overexpand and spend toomuch on capital, which reduces profits and forces retrenchment by management.9 Often young, fast-growing companies may create more valueby spending on capital expenditures, while companies in older, moremature industries, in which agency costs are most severe, pay dividendsor repurchase shares, which is better for shareholders.
The Value of Stock as Related to Dividend PolicyManagement determines its dividend policy by evaluating many factorsincluding the tax impact on shareholders; the need to generate internalfunds to retire debt, invest, or repurchase shares; and the desire to maintain a stable dividend level in the face of fluctuating earnings. Since theprice of a stock depends primarily on the present discounted value of allexpected future dividends, it appears that dividend policy is crucial todetermining the value of the stock.But as long as one specific condition holds—that the firm earns thesame return on its retained earnings as shareholders demand on its stock—thenfuture dividend policy does not impact the market value of the firm.This is because dividends not paid today become retained earnings that8
Benjamin Graham and Seymour Chatman (ed.), Benjamin Graham: The Memoirs of the Dean of WallStreet, New York: McGraw-Hill, 1996, Chap. 11.9See Jeremy Siegel, “Capital Pigs,” The Future for Investors: Why the Tried and the True Triumph over theBold and the New, New York: Crown Business, 2005, Chap. 7.
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generate higher dividends in the future, so that the present value ofthose dividends is unchanged, notwithstanding when they are paid.10The management can, of course, influence the time path of dividends. The lower the dividend payout ratio, which is the ratio of cash dividends to earnings, the smaller the dividends will be in the near future.But over time, dividends will rise and eventually exceed the path of dividends associated with a higher dividend payout ratio. Assuming thefirm earns the same return on investment as the investors require fromthe equity, the present value of these dividend streams will be identicalno matter what payout ratio is chosen.Although earnings drive the dividend policy of the firm, the priceof the stock is always equal to the present value of all future dividendsand not the present value of future earnings. Earnings not paid to investors can have value only if they are paid as dividends or other cashdisbursements at a later date. Valuing stock as the present discountedvalue of future earnings is manifestly wrong and greatly overstates thevalue of a firm.11John Burr Williams, one of the greatest investment analysts of theearly part of the last century and the author of the classic Theory of Investment Value, argued this point persuasively in 1938:Most people will object at once to the foregoing formula for valuing stocksby saying that it should use the present worth of future earnings, not futuredividends. But should not earnings and dividends both give the same answer under the implicit assumptions of our critics? If earnings not paid outin dividends are all successfully reinvested at compound interest for thebenefit of the stockholder, as the critics imply, then these earnings shouldproduce dividends later; if not, then they are money lost. Earnings are onlya means to an end, and the means should not be mistaken for the end.12
A simple example should illustrate this proposition. Assume acompany’s stock is selling for $100 per share and earns 10 percent, or $10per share each year, which, given its risk, is equal to the return investor’sdemand on its stock. If it paid all its earnings as dividends, it would pay$10 per share every year into the future. This stream of dividends, if discounted at 10 percent, yields a $100 share price.10Differential taxes between capital gains and dividends are an exception to this rule. If taxes arehigher on dividends, a high-dividend policy will reduce the value of shares.11Firms that pay no dividends, such as Warren Buffett’s Berkshire Hathaway, have value becausetheir assets, which earn cash returns, can be liquidated and disbursed to shareholders in the future.12John Burr Williams, The Theory of Investment Value, Cambridge, Mass.: Harvard University Press,1938, p. 30.
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If instead the company did not pay a dividend but invested itsearnings in assets whose return is the identical 10 percent, the value ofthe company would remain the same. Yet its earnings would grow to $11per share in the second year, $12.10 in the third, and so on. The presentvalue of these per share earnings, discounted at a 10 percent rate of return, is infinite—clearly a nonsensical value for the firm. This is becausediscounting earnings that are not paid out as dividends is wrong andoverstates the value of the firm. Under the assumptions given, the firmis always worth $100, whether the firm reinvests the earnings at a 10 percent rate of return or pays dividends to the shareholders.The assumption that the firm earns the same rate of return on its retained earnings as the market demands on its stock is a strong one, despite the fact that it is often assumed in capital market theory to resultfrom optimal investment behavior of the firm. But the firm does not always invest optimally, as the previous section suggests. Frequently management engages in expenditures that have a lower return, and in thatcase a policy of paying dividends will result in higher returns to shareholders.
EARNINGS CONCEPTSDespite the dependence of firm value on current and future dividends,dividends are not possible on a sustained basis without positive earnings. As a result, it is critical that a concept of earnings be developed thatgives investors the best possible measure of the sustainable cash that isavailable for the payment of dividends.Earnings, which are sometimes called net income, or profit, are simply the difference between revenues and costs. But the determination ofearnings is not just a cash-in-minus-cash-out calculation since manycosts and revenues, such as capital expenditures, depreciation, and contracts for future delivery, extend over many years. Furthermore, someexpenses and revenues are one-time or “extraordinary” items, such ascapital gains and losses or major restructurings, and they do not addmeaningfully to the picture of the ongoing or sustainable earnings thatare so important in valuing a firm. Because of these issues, there is nosingle “right” concept of earnings.
Earnings Reporting MethodsThere are two principal ways that firms report their earnings. Net incomeor reported earnings are those earnings sanctioned by the Financial Ac-
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counting Standards Board (FASB), an organization established in 1973 toestablish accounting standards. These standards are called the generallyaccepted accounting principles (GAAP), and they are used to compute theearnings that appear in the annual report and are filed with governmentagencies.13The other more generous concept of earnings is called operatingearnings. Operating earnings represent ongoing revenues and expenses,omitting unusual items that occur on a one-time basis. For example, operating earnings often exclude restructuring charges (for example, expenses associated with a firm’s closing a plant or selling a division),investment gains and losses, inventory write-offs, expenses associatedwith mergers and spin-offs, and depreciation of “goodwill.”Operating earnings are what Wall Street watches and what analystsforecast. The difference between the operating earnings a firm reportsand what analysts expect it to report is what drives stocks during the“earnings season,” which occurs in the few weeks following the end ofeach quarter. When we hear that XYZ Corporation “beat the Street,” itinvariably means that its earnings came in above the average (or consensus) forecast of operating earnings.In theory, operating earnings gives a more accurate assessment of thelong-term sustainable profits of a firm than reported earnings gives. Butthe concept of operating earnings is not formally defined by the accounting profession, and its calculation involves much management discretion.As management has come under increasing pressure to beat the Street’searnings forecasts, they are motivated to “stretch the envelope” and exclude more expenses (or include more revenues) than are appropriate.The data show the increased gap between reported and operatingearnings in recent years. From 1970 to 1990, reported earnings averagedonly 2 percent below operating earnings. Since 1991, the average difference between operating and reported earnings has widened to over 18percent, nine times the previous average.14 In 2002, the gap between thetwo earnings concepts widened to a record 67 percent. However, in 2006,this earnings gap had narrowed to about 7 percent.15During the later phases of the bull market of the 1990s, some firms,particularly those in the technology sector, were rightly criticized for ex13
Although earnings filed with the IRS may differ from these.It was partly the favorable reaction of investors themselves that spurred management to increasewrite-offs. In the 1990 to 1991 recession, investors bought firms that had large write-offs because theinvestors believed that those firms would drop losing divisions and become more profitable.15See the S&P 500 Web site on earnings.14
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cluding too many expenses. For example, Cisco Systems wrote off inventories that the firm couldn’t sell and used accounting techniques thatmade its acquisitions appear far more favorable than they were. Somefirms advanced pro forma earnings concepts that involved even moreextreme assumptions. Amazon.com declared it was profitable in 2000 ona pro forma basis if the interest on nearly $2 billion of debt were ignored.
The Employee Stock Option ControversyOne of the most controversial issues is accounting for employee stockoptions. Employee stock options give workers a right to buy stock at agiven price if they have worked for the firm a given period of time, usually five years. The proliferation of stock options given as a part of employee compensation began after the IRS ruled that payment by optionsdid not violate the compensation limitations set by Congress.But options were popular not only because they bypassed restrictions on management compensation but also because most stock options, when granted, did not have to be accounted for as expenses in thefirm’s profit statements. Instead, these options were expensed only ifand when they were exercised.Although the FASB approved this treatment many years ago, therewere many vociferous critics. Nobody put the case for expensing options better than Warren Buffett who stated in 1992, well before this issuetook center stage:If stock options are not a form of compensation, what are they? If compensation is not an expense, what is it? And if expenses shouldn’t go intothe income statement, where in the world should they go?16
Buffett is perfectly correct. Options should be expensed when issued because earnings should reflect the firm’s best determination of the“sustainable flow of profits,” profits that could be paid out as dividendsto shareholders. If employees were not issued options, their regular cashcompensation would have to be raised by the value of the options forgone. Whether the compensation is paid by cash, options, or candy bars,it represents an expense to the firm.When an option is exercised, the firm sells new shares to the optionholder at a discounted price determined by the terms of the option.These new shares will reduce the per share earnings and is called the dilution of earnings. Current shareholders are giving up part of the firm’s16
Berkshire Hathaway 1992 Annual Report.
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profits to new shareholders who, through options, purchased the sharesat below market prices.In 2000 the FASB reversed its position and, following the lead of theInternational Accounting Standards Board (IASB), decided that optionsshould be expensed when granted.Technology firms, heavy users of options, lobbied Congress toblock the FASB from instituting those rules. But after the technologybubble broke, there was clear professional sentiment that options shouldbe expensed, and the FASB set 2006 as the year that firms must expenseoptions. Many firms began expensing options earlier, and by the middleof 2004, 176 firms in the S&P 500, representing over 40 percent of themarket capitalization, expensed options.
Employee Stock Options Lower Risks to StockholdersThe issuance of employee stock options increases the risk borne byshareholders. If the firm experiences poor earnings and the share pricedeclines, then many employee options will expire worthless and thefirm, since it had expensed them, will realize a gain by reversing the expense. On the other hand, if there is good news and the share price rises,then the options will be exercised and per share earnings will decline because of the dilution.The risk that employees shoulder when they accept options insteadof cash compensation thereby reduces the risk to the outside shareholders. This means that a firm that fully expenses the fair value of optionspaid to employees should, all other things equal, be valued slightlymore than firms that pay an equivalent amount of cash in lieu of options.But this also means that much of the upside of technology stocks isenjoyed first by employees exercising their options, which dilutes the interest of outside shareholders. This is an important consideration not always appreciated by those buying stocks in this options-saturated sector.
Controversies in Accounting for Pension Costs
Defined Benefit and Defined Contribution PlansAlmost as contentious as the treatment of options is the accounting treatment of pension costs. There are two major types of pension plans: defined benefit (DB) plans and defined contribution (DC) plans.Defined contribution plans, which gained enormous popularity in the1990s’ bull market, place both the employees’ and employer’s pension
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contributions directly into assets that are owned by the employees. Inthese plans, the firm does not guarantee any benefits. In contrast, in defined benefit plans the employer spells out the income and healthcare benefits that will be paid, and the assets backing these plans are not chosenby or directly owned by the employees.Under government regulations, DB plans must be funded—that is,the firm must place assets in a separate account that will cover the expected benefits associated with these plans. In DC plans, the risk that thevalue of the plan at retirement will not cover retirement expenses istaken by the employees instead of the employers, and it is the employees who must decide where to place their investment dollars.There were two reasons for the tremendous increase in the popularityof the DC plans over the past two decades. One was the great bull market ofthe 1990s that made many employees believe that they could obtain a betterreturn on their own investments than the returns promised by the firm.The second reason was that contributions in a DC plan were immediately vested—that is, they became the property of the employee. If anemployee left the firm, he could take his DC assets with him. In contrast,it takes a number of years before the benefits of a DB plan belong to theemployee. If an employee leaves the firm before these benefits becomevested, then the employee receives no benefit.
Problems and Risks in Defined Benefit PlansCurrent rules for calculating the returns on the assets backing DB plansare generous to the corporations. The FASB allows firms to choose theirown estimate of the rate of return on the assets in their portfolio, andoften these estimates are too high. Furthermore, if the value of the assetsfalls below the pension liabilities (and the fund is called underfunded),the FASB allows firms to close this gap over a substantial period of time.Although the government shortened the period over which firms mustrestore underfunded pensions in the Pension Protection Act of 2006,firms are still allowed to choose their own return estimates.While the government requires firms to build a fund for retirementincome benefits, it does not require them to fund other pension-relatedbenefits, particularly health benefits. In 2003 a Goldman Sachs analystestimated that the healthcare liabilities of the three Detroit automakersamount to $92 billion, roughly 50 percent greater than their combinedmarket capitalizations.1717
David Stires, “The Breaking Point,” Fortune, February 18, 2003.
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Most investors are fully cognizant of these unfunded liabilities andhave taken down the value of the auto manufacturers as well as otherfirms that have large underfunded pension plans. The bankruptcy ofthe steel manufacturers and airlines over the last decade are related totheir inability to meet their pension obligations. By mid-2007, becauseof rising stock prices and interest rates (which help reduce the magnitude of the pension obligation), overall the S&P 500 firms were fullyfunded with respect to their pension obligations but still were about$300 billion underfunded in health and other postretirement employeebenefits (OPEB).18Since virtually all pension plans started in the last 20 years havebeen set up as DC plans and have sharply cut back or eliminated retireehealth benefits, the corporate pension problem will disappear over timeas the risk of funding retirement is shifted to individuals instead of corporations. Nevertheless, it behooves investors to take a close look at thestock of firms with large DB plans as they can be a serious drain on future earnings.
Standard & Poor’s Core EarningsThe dismay over the treatment of pensions and options and the everwidening definition of operating earnings led the Standard & Poor’s corporation in 2001 to propose a uniform method of calculating earningsthat they called core earnings. The objective was to define and measureearnings from a firm’s principal or “core” businesses and to excludefrom earnings revenues or expenses that are incurred for other reasons.Core earnings expenses employee stock options, recalculates pensioncosts, and excludes unrelated capital gains and losses, goodwill impairments, and one-time litigations gains and losses, among others.This unusual and bold stance was taken by the nonregulatory, private sector firm that is the keeper of the world’s most replicated benchmark, the S&P 500 Index. The New York Times called it one the best ideasin 2002.19 Warren Buffett applauded the S&P’s stance, stating in an openletter to David Blitzer, managing director of Standard & Poor’s, “Yourmove is both courageous and correct. In the future, investors will lookback at your action as a milestone event.”2018This was communicated to me by Howard Silverblatt of Standard & Poor’s in an e-mail on June5, 2007.19Tim Carvell, “The Year in Ideas,” New York Times Magazine, December 15, 2002.20Warren Buffett, open letter to David Blitzer, managing director of Standard & Poor’s, May 15, 2002.
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I believe that adopting the concept of core earnings makes a significant move in the direction of standardizing profit statements and iscurrently the best way to measure a firm’s earnings potential.21 Oneshould not underestimate how important this is. A typical firm intoday’s market sells for about 20 times yearly earnings. This means thatonly one-twentieth, or 5 percent, of its price depends on what happensin the next 12 months and 95 percent of its price depends on what happens after that. That is why when we calculate earnings, accounting decisions should distinguish between any one-time gains and losses thatare not expected to be repeated and those that have implications for future profitability. This is what Standard & Poor’s accomplished withcore earnings.
EARNINGS QUALITYGoing beyond Standard & Poor’s core earnings, another way to measurethe quality of earnings is by examining a firm’s accruals, which is definedas accounting earnings minus cash flows.A firm with high accruals may be manipulating its earnings, andthis could be a warning of problems in the future. Alternatively, low accruals may be a good sign that earnings are being conservatively estimated by the firm.There is strong evidence that firms with low accruals have muchhigher stock returns than firms with high accruals. Richard Sloan, a professor at the University of Michigan, was the first to determine that ahigh level of accruals was related to subsequent poor earnings and lowstock returns.22Sloan found that from 1962 through 2001, the difference betweenthe firms with the highest-quality earnings (lowest accruals) and thosewith the poorest-quality earnings (highest accruals) was a staggering 18percent per year. Further research indicated that despite the importanceof accruals, Wall Street analysts did not take this into account when forecasting future earnings growth.21
The core earnings concept is the brainchild of David Blitzer, managing director and chairman ofthe Index Committee, Robert Friedman, Howard Silverblatt, and others.22Richard Sloan, “Do Stock Prices Reflect Information in Accruals and Cash Flows about FutureEarnings?” Accounting Review, vol. 71 (1996). High levels of accruals are also associated with moreSEC enforcement actions, earnings restatements, and class action lawsuits, all of which have negative implications for stock returns. Also see Richard Sloan, Scott Richardson, Mark Soliman, andIrem Tuna, “Accrual Reliability, Earnings Persistence and Stock Prices,” Journal of Accounting andEconomics, vol. 39 (2005).
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Determining earnings will always be fraught with estimates, evenif made in good faith. The bottom line is that cash flows, as well as dividends, are much harder to manipulate than earnings.
DOWNWARD BIASES IN EARNINGSAlthough some accounting conventions work in a favorable directionfor the firm, there are many that work in the opposite direction. For example, research and development costs are routinely expensed althoughthere is good reason to capitalize these expenditures and then depreciatethem over time.23 This means that the earnings of firms with a high levelof R&D expenditures, such as the pharmaceutical industry, may be understating their earnings.Take Pfizer, the largest drug stock in the world and one of the 10largest companies in the S&P 500 in March 2007. In 2006, Pfizer spent$7.6 billion on research and development for drugs and slightly over $2billion on plants and equipment. Governed by current accounting rules,Pfizer subtracted from its earnings only 5 percent of the $2 billion itspent on plant and equipment as depreciation because the remainderwould be deducted over the useful life of these assets.But 100 percent of the $7.6 billion Pfizer spent on research and development was subtracted from its earnings. This is because Pfizer’sR&D is not considered an asset under these accounting definitions, andit must be expensed when the expenditures are made.Does this make sense? Is Pfizer’s R&D less of an asset than its property, plants, and equipment? Considering that Pfizer’s value largelystems directly from the patents it gains through its research and development expenditures, this accounting treatment seems to cast too negative a shadow on Pfizer’s performance.Leonard Nakamura, an economist at the Federal Reserve Bank ofPhiladelphia, believes this is the case. “It’s really those [R&D] expenditures that are going to drive long-run corporate performance,” he hasstated.24 Thus, in many ways, especially for industries with intensive research and development, current earnings measures understate the future earnings potential of the corporation and economic reality.Another understatement comes from the treatment of interest expense. Interest expenses are deducted from corporate earnings even23
Leonard Nakamura, “Investing in Intangibles: Is a Trillion Dollars Missing from GDP?” BusinessReview, Federal Reserve Bank of Philadelphia, Fourth Quarter 2001, pp. 27–37.24Cecily Kump, “Innovation,” Forbes, July 5, 2004.
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though inflation, which raises interest costs, causes a corresponding reduction in the real value of corporate debt. In inflationary times the impact of rising prices on fixed corporate liabilities could be substantial.The bottom line is that some accounting practices understate thetrue earnings of firms.
HISTORICAL YARDSTICKS FOR VALUING THE MARKETMany yardsticks have been used to evaluate whether stock prices areovervalued or undervalued. Most