In 1991, Barrie Wigmore, a Goldman Sachs limited partner, released a study that attempted to determine what factors drove the stock market’s above-average returns in the decade of the 1980s. After carefully accounting for earnings growth, interest rate declines, M&A activity and analysts’ rosy forecasts, it appeared a full 38% of the shareholder value created in the 1980s remained unexplained. Dubbed the “X” factor, this mysterious driver of value left Wigmore and the Wall Street Journal, which published a feature article on the study, at a loss. Given overwhelming evidence of well-functioning capital markets, it appears completely unsatisfactory to attribute such a large component of share price performance to some unidentifiable and seemingly inexplicable force.
Fortunately, there is an answer to this problem. However, to understand the solution there must be a recognition that share prices are not set by capitalizing accounting-based earnings, which are at best flawed and at worst substantially misleading. The focus must be on the economic drivers of a business, which can be defined as cash flow (cash-in versus cash-out), risk (and appropriate demanded return) and what is dubbed “competitive advantage period”— CAP— or how long returns above the cost of capital will be earned. CAP is also known as “value growth duration”.
In this context, Mr Wigmore’s “X” factor can be explained by the market’s extension of expectations for above-cost-of-capital returns. As Mr Wigmore’s analysis suggests, the length and relative change of CAP can have a substantial impact on the value of a business and the market overall. For example, the revision in expectations of Corporate America’s ability to generate returns above its cost of capital is a powerful indicator that investors believed that America was more competitive at the end of the 1980s than it was entering the decade. This conclusion was later supported by economic analysis. It should be noted that in a well-functioning capital market all assets, including bonds and real estate, are valued using similar economic parameters. In the case of bonds, for example, the coupon rate (or cash flow) is contractually set, as is the maturity. The bond price is set so that the expected return of the security is commensurate with its perceived risk. Likewise for most commercial real estate transactions. At the end of the day, the process of investing returns to the analysis of cash flow, risk and time horizon. Since these drivers are not contractually set for equity securities, they are by definition expectational and, in most cases, dynamic.
Remarkably, in spite of CAP’s importance in the analytical process it remains one of the most neglected components of valuation. This lack of focus appears attributable to two main factors. First, the vast majority of market participants attempt to understand valuation and subsequent stock price changes using an accounting-based formula, which generally defines value as a price/earnings multiple times earnings. Thus CAP is rarely explicitly addressed, even though most empirical evidence suggests that the stock market deems cash flow to be more important than earnings, holds true to the risk/reward relationship over time, and recognizes cash flows many years into the future.
Second, most companies use a forecast period for strategic planning purposes (usually three to five years) that is substantially different from their CAP. As a result, investor communication is geared more toward internal company-based expectations rather than external market-based expectations. If the determination of stock prices is approached with an economically sound model, the concept of CAP becomes immediately relevant.
Fortunately, there is an answer to this problem. However, to understand the solution there must be a recognition that share prices are not set by capitalizing accounting-based earnings, which are at best flawed and at worst substantially misleading. The focus must be on the economic drivers of a business, which can be defined as cash flow (cash-in versus cash-out), risk (and appropriate demanded return) and what is dubbed “competitive advantage period”— CAP— or how long returns above the cost of capital will be earned. CAP is also known as “value growth duration”.
In this context, Mr Wigmore’s “X” factor can be explained by the market’s extension of expectations for above-cost-of-capital returns. As Mr Wigmore’s analysis suggests, the length and relative change of CAP can have a substantial impact on the value of a business and the market overall. For example, the revision in expectations of Corporate America’s ability to generate returns above its cost of capital is a powerful indicator that investors believed that America was more competitive at the end of the 1980s than it was entering the decade. This conclusion was later supported by economic analysis. It should be noted that in a well-functioning capital market all assets, including bonds and real estate, are valued using similar economic parameters. In the case of bonds, for example, the coupon rate (or cash flow) is contractually set, as is the maturity. The bond price is set so that the expected return of the security is commensurate with its perceived risk. Likewise for most commercial real estate transactions. At the end of the day, the process of investing returns to the analysis of cash flow, risk and time horizon. Since these drivers are not contractually set for equity securities, they are by definition expectational and, in most cases, dynamic.
Remarkably, in spite of CAP’s importance in the analytical process it remains one of the most neglected components of valuation. This lack of focus appears attributable to two main factors. First, the vast majority of market participants attempt to understand valuation and subsequent stock price changes using an accounting-based formula, which generally defines value as a price/earnings multiple times earnings. Thus CAP is rarely explicitly addressed, even though most empirical evidence suggests that the stock market deems cash flow to be more important than earnings, holds true to the risk/reward relationship over time, and recognizes cash flows many years into the future.
Second, most companies use a forecast period for strategic planning purposes (usually three to five years) that is substantially different from their CAP. As a result, investor communication is geared more toward internal company-based expectations rather than external market-based expectations. If the determination of stock prices is approached with an economically sound model, the concept of CAP becomes immediately relevant.
No comments:
Post a Comment