Isn’t it time to replace stock prices with a valuation rating that truly reflects the financial health of a company? Preposterous, you say. Well, maybe not.
C-Suites, shareholders and the investment community view high stock prices as the Holy Grail for determining a company’s value. Why? A consistently high stock price can result in big rewards for a CEO in the form of salary increases and large bonuses. Shareholders benefit as well with higher returns on their investments. What’s not to like?
With incentives like that, why shouldn’t a CEO of a company with mediocre results aspire to become a Wall Street star by cutting staff and R&D to reduce costs to elevate its profitability and its stock price? The company’s cash flow problems and lack of a pipeline for new products can wait.
Short-term Gain at the Expense of Long-term Growth
I admit that the scenario above is a bit simplistic. Sadly, however, there have been several examples of companies that have had bad endings by focusing on a high stock price at the expense of solid cash flows, new and innovative products, hiring good people and other steps to build long-term value. Blackberry and Kodak immediately come to mind.
In the April 6, 2015 edition of Time magazine, business commentator Rana Foroohar described using stock prices to show a company’s value as “One of the hardest dying ideas in economics.” She called stock prices “short-term distractions” and noted that Wall Street punishes any firm that takes steps to create real economic value, such as improved cash flow and invest in R&D that lowers the company’s stock price.
A few days later, Bloomberg’s Barry Ritholz argued that the Dow Jones Industrial Average and Standard & Poors 500 Index provided a truer picture of a company’s financial health after shifting to a market-capitalization weighted approach from the price-weighted approach. But, he now worries that several large and well-known companies listed on the S&P and Dow Jones averages have been under performing but continue to attract an inordinate amount of investment, regardless of their true valuations. As the S&P and Dow Jones continue to rise, more investments come in. But when stock prices start to peak and then fall, the capital markets and investors, especially, feel the pain. Then, the same cycle starts all over again.
The debate over the capital market’s obsession with stock prices as a primary measure of a company’s true value has been going on for decades. In 1974, one of the bulwarks of American capitalism, The Wall Street Journal, published an editorial questioning the logic of basing a company’s value on earnings per share.
“A lot of executives apparently believe that if they can figure out a way to boost reported earnings, their stock prices will go up even if the highest earnings do not represent any underlying economic change. In other words, the executives think they are smart and the market is dumb…The market is smart. Apparently the dumb one is the corporate executive caught up in the earnings-per-share mystique.” *
Learn or Ignore the Lessons from the Great Recession
Forty-one years later the debate still rages. However, the stakes on the outcome for the global capital markets are very high. The Great Recession of 2009 revealed how fragile the global financial markets were to the actions of many major Wall Street players who were under the spell of high-risk credit default swaps of mortgage-backed securities.
If Wall Street were to start placing less value on stock price and more emphasis on cash flow, R&D and other factors that show the true value and long-term sustainability of a company, it would be an important step towards removing another misleading mystique that continues to undermine the stability of the capital markets and erode investor confidence.
*Copeland, T, Koller, T. Murrin, J. Valuation: Measuring and Managing the Value of Companies, John Wiley & Sons, Inc., 1995, p. 71