Valuation: Measuring and Managing the Value of Companies, Fifth Edition

16

Markets Value Substance, Not Form

As shown in the previous chapter, stock market valuations reflect companies’ long-term return on invested capital (ROIC) and revenue growth, the economic fundamentals that drive their long-term cash flows. Yet many managers remain obsessed by the representation of cash flows rather than their quality, an obsession demonstrated by managers’ efforts to meet earnings per share (EPS) targets, to remain included in a major stock index, or to obtain a cross-listing. Such managers believe these efforts are critical to maintaining or improving their share price. But as evidence presented in this chapter demonstrates, capital markets are not moved by such efforts in the long term. Ultimately, the measures of real value creation—ROIC and growth—are the only drivers of market value.

• Managers can go to great lengths to achieve analysts’ expectations of EPS or to smooth earnings from quarter to quarter. But the evidence shows clearly that stock markets reward neither predictable nor smooth earnings. A company’s share price is driven by its long-term economic fundamentals.

• Stock markets are perfectly capable of seeing the economic reality behind different forms of accounting information. Therefore, managers should not be overly concerned with how their share price might be affected by new accounting rules (for instance, changes in the treatment of options or goodwill), since these do not affect their underlying economics.

• Since investors value substance ...