Download (direct link):
Conversely, the market also reacts favorably when companies write off bad investments, despite the negative short-term earnings impact. While the complex nature of write-offs prohibits comprehensive statistical analysis, Mercer looked at 40 major write-offs from 1984 to 1986 and found that 60 percent of them resulted in share price increases.11 Furthermore, 75 percent of writedowns resulting from abandonment of entire businesses were associated with share price increases.
More evidence supporting the view that the market values cash, not earnings, emerges from changes in leverage and their impact on share prices and earnings per share. Copeland and Lee (1988) studied 161 exchange offers and stock swaps from 1962 to 1984.12 The study showed that the earnings-per-share impact of the transaction did not matter. What mattered was whether the transaction was leverage-increasing or leverage-decreasing. Following are the average percentage changes in share value upon the announcement of the transactions relative to the changes in the market average:
EPS-increasing transactions EPS-decreasing transactions
Leverage-increasing transactions 3.77 8.41
Leverage-decreasing transactions -1.18 -0.41
On average, leverage-decreasing transactions resulted in negative share price reactions, regardless of the earnings-per-share impact. Copeland and Lee also concluded that the most likely explanation for the direction of the share price movements was that investors interpret leverage-changing transactions as management signals of the direction of cash flow. Such transactions could signal strong cash flows in the future, leading corporate insiders to increase their share holdings in the company.
Implications of Market Inefficiency for Corporate Managers
Sometimes managers point to evidence of inefficiency in the stock market to justify their belief that the market behaves irrationally. These managers would argue that even academics are finding inefficiencies in the market, so any argument supporting the discounted cash flow approach would not
11 G. Mercer, ''A Review of Major Corporate Writeoffs, 1984-86" (McKinsey & Co., 1987).
12 T. Copeland and W.H. Lee, "Exchange Offers and Stock Swaps—New Evidence," Financial Management, vol. 20, no. 3 (autumn 1991), pp. 34-48.
square with the real world. We would argue that even if the market is occasionally inefficient, managers should make business decisions as if the market were efficient.
It has been more than 30 years since the concept of efficient markets was proposed. It is one of the most debated and researched ideas in economics, if not all the social sciences. Yet it is also one of the most misunderstood. Many business people believe that the theory of efficient markets means that the stock market always ''gets it right." The ambitions of efficient markets theory are much more modest. In layman's terms, a market is efficient if new information is quickly or instantaneously reflected in share prices. Essentially, this means that it is hard for investors to beat the market unless they have better information than the market as a whole. Trading-oriented strategies, such as momentum trading, are unlikely to generate market-beating returns.13
Ever since academics suggested that the stock market behaves efficiently, researchers have been looking for anomalies to refute the thesis. While the debate is unresolved, it is fair to say that some anomalies have been identified. The question relevant for us is what are the implications of market inefficiencies for investors and corporate managers.
For investors, it is clear that this represents an opportunity to make money. To exploit these inefficiencies, however, requires massive computing power and the ability to execute stock trades instantly. As with most market inefficiencies, only the biggest and quickest investors are likely to benefit. In any case, once these inefficiencies become known, they usually disappear and the search is on for new ones.
What are the implications for corporate managers? As long as your company's share price returns to its long-run DCF value, you might as well use the DCF approach for strategic decisions. What should matter is the long-term behavior of the company's share price, not whether it is 5 percent undervalued this week.
If you can systematically identify when your company's stock is misvalued, you could try to use that information to determine when to sell more shares (or use shares to pay for an acquisition) or buy back shares. But for strategic business decisions, the evidence strongly suggests that the market acts more like it is using the DCF approach than the accounting approach.
13 For an excellent summary of the history and current debate, see R. Ball, "The Theory of Stock Market Efficiency: Accomplishments and Limitations," The New Corporate Finance, ed. D. Chew, Jr. (New York:
Irwin McGraw-Hill, 1999), pp. 35-48.
Managers who use the DCF approach to valuation, focusing on increasing long-term free cash flow, ultimately will be rewarded by higher share prices. The evidence from the market is conclusive. Naive attention to accounting earnings will often lead to value-destroying decisions.