Chapter 5 - Cash Is King
Quote from an expert in the field
“Everything we do should increase the Net Present Value of the company”
Mo Vaziri (April 02,2003)
Chapter 5 - Cash Is King
Valuation Methods
Traditional Accounting Measurements
Balance Sheet (On and Off) Income Statement Statement of Owners Equity Statement of Cash Flows
New Paradigm
Free Cash Flow Cost of Investing Return on Invested Capital
Chapter 5 - Cash Is King
Manner in which market functions
1) Changes in value are linked more closely to changes in expectations than to absolute performance.
In 1997 Intel reported 19% earnings growth and stock declined 6.3% because of 23% forecast.
Chapter 5 - Cash Is King
Relationship between TRS and Expected Performance (p.75)
See Exhibit 5.1 on page 75
Chapter 5 - Cash Is King
Manner in which market functions
2) Valuation levels are linked to return on invested capital and growth.
Authors conducted a survey of 340 large companies Five year growth Five year average spread (ROIC vs Opportunity Cost of Capital) Average Market/Book Value
Chapter 5 - Cash Is King
Relationship between Market Values, Spread, and Growth (p.76)
See Exhibit 5.2 on page 76
Chapter 5 - Cash Is King
More Regression Analysis for you Statisticians… (p.77)
See Exhibit 5.4 on page 77
Chapter 5 - Cash Is King
More Regression Analysis for you Statisticians… (p.77)
See Exhibit 5.5 on page 77
Chapter 5 - Cash Is King
Manner in which market functions
3) The market sees through cosmetic earnings effects and focuses on underlying economic results.
Not fooled easily by creative accounting Accounting methods used in different countries. Inventory Valuation methods Mergers and Aquisitions
Chapter 5 - Cash Is King
German Industrial Company - Hoechst
Year
German accounting(DM million)
U.S accounting(DM million)
Difference (percent)
1995 1,709 (57) NM
1996 2,114 1,324 -37%
1997 1,343 377 -72%
Chapter 5 - Cash Is King
Inventory Valuation
Choice of accounting method affects both earnings and cash flow – in opposite directions.
In periods of rising prices: LIFO = lower earnings, lower income taxes, higher
after-tax cash flow. FIFO = just the opposite.
Chapter 5 - Cash Is King
Mergers and Acquisitions
Purchase: Price Paid – Book Value = Goodwill (amortized over 40 years)
Pooling of Interests: Reported at Book Value with no amortization. Earnings are higher without amortization
Chapter 5 - Cash Is King
Manner in which market functions
4) The market puts great weight on long-term results, not just short-term performance.
Internet Companies – valued very high even without earnings or products to sell.
Dividends as percentage of stock price. Market reacts favorably to increases in
investment Changes in Leverage
Chapter 5 - Cash Is King
Long-Term Investment
Type of Investment Sample Size
Cumulative 2-day market adjusted return (percent)
Capital Expenditures 260 +0.35
Product Strategies 168 +0.84
R&D Expenditures 45 +1.20
Joint Venture Formations 161 +0.78
Total Sample 634 +0.71
Chapter 5 - Cash Is King
Market values CASH, not earnings
Exchange and Stock Swap TransactionsEPS impact does not matterChange in Leverage matters
Decrease in Leverage = negative share price reaction
Chapter 5 - Cash Is King
Is the Stock Market Efficient? Some managers claim that the market
behaves irrationally.
Does ‘efficient’ mean “Get it Right”?
What are the implications for investors and corporate managers?