Finance Basics, part 8

It is difficult to see how a company with nothing, promising to do nothing, could be worth $22.9 million. In Spring 2000 it was a tough job explaining market efficiency, let alone rationality. This leads to point number eight. The equity market may be broadly efficient, but that does not mean equity prices are accurate signals of the fundamentals in the economy. This is what is meant by allocational and productive efficiency.

Ideally, high profits in any sector of the economy indicate high consumer demand and the need for firms to produce more. This is the heart of a free-enterprise, competitive economy with the equity market at the heart of this process. High profits end up being capitalized into equity prices, with prices increasing above book value, so that high market-to-book ratios indicate that new investment and production are needed. But what of the Internet bubble? The signals given in the late 1990s were that Internet companies, like E-Toys were really valuable; consequently, broadband communication companies, like WorldCom, were valuable and so, too, the equipment makers, such as Cisco and Lucent. The extremely high valuation on these technology stocks provided the signal to the real economy to expand production in those areas.

Unfortunately, those valuations were not the result of high profits: Consumers had not indicated they were demanding or willing to pay large amounts of money for broadband connections and Internet services. The stock market valuations were not based on financial projections, but a “new age of investing,” and it turns out that those signals were hopelessly wrong. We now have a glut of production in most technology areas and large numbers of bankruptcies. In terms of the signal that the equity market gives to managers, we have to remember that it is a very noisy signal. Unlike the fixed income market, it doesn’t always pay to listen to the equity market.

Point number nine is another corollary of potential equity market deviations from fundamentals, which is that executive stock options are not the panacea that finance people have been claiming in terms of executive compensation. The basic assumption justifying executive stock option grants is that they motivate managers to act like stockholders, and further that managers can, by their actions, influence the value of the firm.

In the late 1990s, during the bubble in Internet and technology stocks, it was quite clear that it wasn’t the actions of the managers that were influencing stock prices. The economic fundamentals of these sectors were overwhelmed by the stock market bubble in prices. As a result, managers at many of the Internet and technology companies were actively exaggerating and fermenting the bubble in their stock prices. For many Internet startups, the first senior appointment was not in finance or marketing, but in public relations, to keep a stream of information coming to the market to hype the stock price.

Clearly, there has to be a realignment of the value of executive stock options as a compensation tool. We can’t just allow firms to award executive stock options and not include their cost in the financial statements. For many firms this practice vastly understates the true cost of their operations and distorts both the labor market and the stock market. Further, the practice of lowering the exercise price when the stock price goes down, so that the executive is guaranteed to exercise sooner or later, removes any coincidence of interests with stockholders, who have no such opportunities.

Finally, point number ten is that corporate financial policy isn’t as important as corporate investment policy. Whatever the firm is doing in terms of its financing – in terms of its debt-equity ratio and of its dividend policy – is of relatively minor importance compared to the fundamentals of actually producing profitable products. This is the classic proposition that earned Professors Franco Modigliani and Merton Miller the Nobel Prize. I would guess that the performance of Enron and the use of special-purpose vehicles has brought home to people that financial chicanery can transfer value, sometimes huge amounts of value, from one group to another, but it does not create value.