Expectations Investing Reading Stock
Expectations Investing Reading Stock
Expectations Investing Reading Stock
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To Sharon
To Michelle
The Dual Uses of Competitive Strategy Analysis
Historical Analysis
Competitive Strategy Frameworks
Essential Ideas
11 Share Buybacks
The Golden Rule of Share Buybacks
Four Popular Motivations for Share Buybacks
Essential Ideas
12 Incentive Compensation
CEO and Other Corporate-Level Executives
Operating-Unit Executives
Middle Managers and Frontline Employees
Essential Ideas
Notes
Index
About the Authors
Assets producing cash flows will ultimately return the owner’s investment without depending on the
whims of other investors. Even if those cash flows are some distance in the future, their prospects endow
them with a present value. Financial markets are nothing more than arenas where investors who need cash
today can obtain it by selling the present value of future cash flows to other investors willing to wait for
the cash payoffs from their capital. The payment medium in this transaction is money. The crucial point: If
you invest without expecting future cash flows, then you might as well collect art or play the slot
machines.
The tension in this book demands our attention. It focuses on future cash flows, but we never know for
certain what the future holds. We cannot even count on the cash flows from U.S. Treasury obligations—
perhaps less uncertain than other cash flows, but uncertain nevertheless. The fundamental law of
investing is the uncertainty of the future.
How, then, can a rational investor derive the value of a future stream of cash, even a contractual one
such as promised in a debt instrument? Rappaport and Mauboussin walk their way around this question by
telling their readers not to answer it. I kid you not. Instead, the authors advise readers to let other
investors answer the question! And their answers come through, loud and clear, in the prices paid for
financial assets in the capital markets. As Rappaport and Mauboussin remind us repeatedly, stock prices
(and bond prices, too) are a gift from the market, a gift of information about how other investors with
money on the line are estimating the value of future cash flows.
If the market’s generosity in providing key information were the whole story, then the authors would
have written a pamphlet instead of a plump volume. But the market price is only the beginning, not the
end. Investors still have hard work to do. We may be able to glean what other investors expect, but we
should not accept those expectations without qualification. We must test the beliefs of the market, and here
Rappaport and Mauboussin are at their best. They set forth a systematic testing process to guide the
investor toward a reasoned judgment about both the company involved and the market’s expectations,
ultimately to determine whether to buy, sell, or hold.
Long experience in the capital markets reveals few lessons valid for all times; but, in half a century as
a professional investor, I have found one particularly robust: The secret of success in maximizing the
treasures of instruction in this book is silence. This important piece of advice to investors applies
especially to Expectations Investing.
You need no ears to carry out the method recommended by Rappaport and Mauboussin. You can easily
find everything you need, in print or on the Internet, specifically in market prices that reflect the views of
investors willing to put their money where their mouths are, in publicly available corporate financial
statements, and in the consensus forecasts published by reputable sources. Armed with this assemblage of
data, you need not listen to the cacophony of recommendations flooding the investment community every
minute of every day, no matter how exciting or lofty the sources of those recommendations. You can
follow the actions of investors, not the advice of the gurus. The more you succeed in shutting your ears to
all the other voices assailing investors, the more you will succeed in your investing. Let your eyes, not
your ears, inform your brain.
Reading the tea leaves as described by Rappaport and Mauboussin is no simple task, although their
recommended process is direct and uncluttered. No method of security selection will ever guarantee you
success in a dynamic economy where the future always eludes you. The trick is to know where you are
going, why you are going there, and why you must ignore any approach that lacks a logical path to the
heart of value. The methodology of Expectations Investing meets all three requirements. As I suggested
above, don’t confuse stock picking with art collecting.
value of uncertain future opportunities for these companies. Chapter 9 classifies companies into three
business categories—physical, service, and knowledge. While each category has distinct characteristics,
we show expectations investing is applicable to all companies across the economic landscape.
Finally, in chapters 10 through 12 (part III, “Reading Corporate Signals”), we examine three
corporate transactions—mergers and acquisitions, share buybacks, and incentive compensation—that
involve stock and often provide important signals to investors. Specifically, we show how decisions to
finance acquisitions, to repurchase stock, and to use stock options for incentive compensation can reveal
management’s view of the company’s prospects compared to the market’s expectations.
Please visit us at www.expectationsinvesting.com.
• Over 50 million U.S. households—nearly one in two—own mutual funds. Many more
individuals participate in the stock market directly through stock ownership and self-directed
retirement accounts, or indirectly through pension programs. Around the globe, expectations
investing can provide investors with a complete stock-selection framework or, at a minimum, a
useful standard by which they can judge the decisions of their portfolio managers.
• Investors quickly withdraw money from poorly performing funds. Money managers who use
outdated analytical tools risk performing poorly and losing funds. Expectations investing applies
across the economic landscape (old and new economy) and across investment styles (growth
and value).
• Lured by reduced trading costs, better access to information, the disappointing record of active
managers, and the fun of managing money, many individual investors are shunning actively
managed mutual funds and overseeing their own investments. In fact, individuals managed over
28 million online trading accounts in the United States in 2000, and online trades exceeded one-
third of retail trading volume in equities. If you currently manage your investments or are
considering the possibility, then expectations investing can improve your odds of achieving
superior performance.
• More than ever before, major corporate decisions such as merger-and-acquisition (M&A)
financing, share buybacks, and employee stock options rely on an intelligent assessment of a
company’s stock price. These decisions to issue or repurchase shares might signal the market to
revise its expectations. Expectations investing provides a way to read management’s decisions
and anticipate revisions in market expectations.
Expectations investing is a practical application of sound theory that many companies have used over
the past couple of decades. The process includes the principles of value creation and competitive strategy
analysis. We tailor these tools specifically for investors, creating a new integrated power tool kit for
investors.
Succeeding at active investing will only get harder. With an accelerating rate of innovation, greater
global interdependence, and vast information flows, uncertainty has notably increased. We believe that
expectations investing can translate this heightened uncertainty into opportunity. Further, the U.S.
Securities and Exchange Commission Regulation FD (“fair disclosure”), implemented in late 2000,
requires companies to disclose material information to all investors simultaneously so that no one gets an
informational edge.
Tools
Standard practice: Most investors use accounting-based tools, like short-term earnings and price-
earnings multiples. These inherently flawed measures are becoming even less useful as companies
increasingly depend on intangible rather than tangible assets to create value. We expand on the
shortcomings of earnings as poor proxies for market expectations in the last section of this chapter.
Expectations investing draws from modern finance theory to pinpoint the market’s expectations. It
then taps appropriate competitive strategy frameworks to help investors anticipate revisions in
expectations.
Costs
Standard practice: John Bogle, founder of The Vanguard Group, correlates costs to mutual fund
performance, averring that “the surest route to top-quartile performance is bottom-quartile expenses.”5
Annual operating and management investment expenses for equity funds average about 1.5 percent of asset
value. In addition, mutual funds pay broker commissions of another 1 percent or so because of high
portfolio turnover. With total costs that average about 2.5 percent per year, investors earn only 75 percent
of an annual long-term return of 10 percent—excluding the impact of taxes. In contrast, index funds have
lower operating expenses and relatively low transaction costs.6
Expectations investing establishes demanding standards for buying and selling stocks, resulting in
lower stock portfolio turnover, reduced transaction costs, and lower taxes.
Incentives
Standard practice: Fund shareholders generally compare their returns quarterly to a benchmark, usually
the S&P 500. Fund managers often fear that, if they fail to achieve acceptable short-term performance,
then they will lose substantial assets, their jobs, and, ultimately, the opportunity to achieve superior long-
term returns. Naturally, these managers obsess over short-term relative returns. If they shift from
identifying mispriced stocks to minimizing the variance from the benchmark, then they blunt their odds of
outperforming index funds.
Expectations investing improves the probability of beating the benchmark over longer periods,
provided that the fund manager can buck the system and embrace more effective analytical tools.
Style Limitations
Standard practice: Most professional money managers classify their investing style as either “growth” or
“value.” Growth managers seek companies that rapidly increase sales and profits and generally trade at
high price-earnings multiples. Value managers seek stocks that trade at substantial discounts to their
expected value and often have low price-earnings multiples. Significantly, fund industry consultants
discourage money managers from drifting from their stated style, thus limiting their universe of acceptable
stocks.
Expectations investing doesn’t distinguish between growth and value; managers simply pursue
maximum long-term returns within a specified investment policy. As Warren Buffett convincingly argues,
“Market commentators and investment managers who glibly refer to ‘growth’ and ‘value’ styles as
contrasting approaches to investment are displaying their ignorance, not their sophistication. Growth is
simply a component—usually a plus, sometime a minus—in the value equation.”7
Further, not only does expectations investing help identify undervalued stocks to buy or hold, it also
identifies overvalued stocks to avoid or sell in the investor’s target universe.
Does expectations investing offer insightful, dedicated investors a reasonable probability of achieving
superior returns? We think so.
In 1976, Jack Treynor distinguished “between ideas whose implications are obvious” and those “that
require reflection, judgment, and special expertise for their evaluation.” The latter ideas, he argued, are
“the only meaningful basis for long-term investing.”8 When companies announce earnings surprises,
mergers and acquisitions, a new drug, or a government antitrust action, the long-term valuation
implications are rarely obvious. Investors quickly assess the effects, favorable or unfavorable, on current
price, and they trade accordingly. Not surprisingly, trading volume typically increases after these
announcements. Volatile stock prices and increased trading volume affirm that investors quickly respond
to such information. But what distinguishes the winners from the losers is not how quickly they respond,
but how well they interpret the information. Different investors interpret the same information differently,
and some interpretations are much better than others.
In other words, stock prices quickly reflect revised but perhaps misguided expectations; therefore, to
succeed, investors must first skillfully read expectations and then use the best available tools to decide
whether and how today’s expectations will change. Welcome to expectations investing.
• The long-term discounted cash-flow model is the right tool to read expectations because it
mirrors the way the market prices stocks.
• Expectations investing solves a dilemma that investors face in a world of heightened uncertainty
by allowing them to harness the power of the discounted cash-flow model without forecasting
long-term cash flows.
• Expectations investing methodology reveals whether the stock price is most sensitive to
expectations revisions in the company’s sales, operating costs, or investment needs so that
investors can focus on the potential revisions that affect price most.
• Expectations investing applies the best available competitivestrategy frameworks in the
investor’s search for potential expectations revisions.
• Expectations investing provides the tools to evaluate all public companies—old and new
economy, value and growth, developed and emerging market, start-up and established.
Expectations investing applies universally.
• Prospective buys or sells must offer a clear-cut “margin of safety.” A buy candidate, for
example, must trade at a sufficient discount to its expected value.
• Key insights from behavioral finance help investors avoid decision-making pitfalls.
• The use of demanding buy and sell hurdles reduces transaction costs and income taxes.
Most investors (and corporate managers) believe that short-term reported earnings rather than long-
term cash flows fuel stock prices. Why? There are three plausible explanations.
The first is a misinterpretation of the stock market’s response to earnings announcements. When
quarterly earnings announcements provide investors with new information about a company’s long-term
cash-flow prospects, the stock price changes. But the market does not react mechanically to reported
earnings. Rather, it uses unexpected earnings results as a signal to revise expectations for a company’s
future cash flows when appropriate. If the market interprets a disappointing earnings announcement as a
sign of a longer-term downturn, then it drives the stock price down.10
Second, the stocks of businesses with excellent long-term prospects do not always deliver superior
shareholder returns. If a company’s stock price fully anticipates its performance, then shareholders should
expect to earn a normal, market-required rate of return. The only investors who earn superior returns are
those who correctly anticipate changes in a company’s competitive position (and the resulting cash
flows) that the current stock price does not reflect.
Finally, commentators frequently point to short (and shortening) investor holding periods to support
their belief that the market is shortterm. John Bogle notes that the average holding period for funds has
plummeted from about seven years in the mid-1960s to just over a year by 2000.11 How can investors
who hold stock for months, or days, care about a company’s long-term outlook?
This conundrum has a simple solution: Investor holding periods differ from the market’s investment
time horizon. To understand the horizon, you must look at stock prices, not investor holding periods.
Studies confirm that you must extend expected cash flows over many years to justify stock prices.
Investors make short-term bets on long-term outcomes.
How do we know that the market takes the long view? The most direct evidence comes from stock
prices themselves: We can estimate the expected level and duration of cash flows that today’s price
implies. As it turns out, most companies need over ten years of value-creating cash flows to justify their
stock price.
Indirect evidence comes from the percentage of today’s stock price that we can attribute to dividends
expected over the next five years. Only about 10 to 15 percent of the price of stocks in the Dow Jones
Industrial Average results from expected dividends for the next five years.12
The investment community undeniably fixates on EPS. The Wall Street Journal and other financial
publications amply cover quarterly earnings, EPS growth, and price-earnings multiples. This broad
dissemination and frequent market reactions to earnings announcements might lead some to believe that
reported earnings strongly influence, if not totally determine, stock prices.
The profound differences between earnings and long-term cash flows, however, not only underscore
why earnings are such a poor proxy for expectations, but also show why upward earnings revisions do not
necessarily increase stock price. The shortcomings of earnings include the following:
Discounted cash-flow models, and stock prices, account for the time value of money: A dollar today
is worth more than a dollar a year from now because we can invest today’s dollar to earn a return over
the next year. So when a company invests, it must compare its return to those of alternative, equally risky
investment opportunities. This opportunity cost, or cost of capital, is the discount rate for a discounted
cash-flow model. Earnings calculations, in contrast, ignore this opportunity cost.
In a discounted cash-flow model, value increases only when the company earns a rate of return on
new investments that exceeds the cost of capital. However, a company can grow earnings without
investing at or above the cost of capital. (See the appendix at the end of this chapter for a detailed
example.) Consequently, higher earnings do not always translate into higher value.
Consider the second difference—the required investments in working capital and fixed capital.
Earnings do not recognize the cash outflows for investments in future growth, such as increases in
accounts receivable, inventory, and fixed assets. Discounted cash-flow models, in contrast, consider all
cash inflows and outflows. The Home Depot’s fiscal 1999 net income was $2,320 million, whereas its
cash flow was only $35 million (table 1-1). What does the first figure tell you about the second one, in
either the near or the long term? Very little.
An analysis of cash flow as a percentage of net income for the thirty Dow Jones Industrial Average
companies shows a similar result: Cash flow was about 80 percent of earnings for the group, and earnings
exceeded cash flow for twenty-three of the thirty companies.13
Finally, companies can use a wide range of permissible methods to determine earnings. How
accountants record a business event does not alter the event or its impact on shareholder value.
Enlightened accountants readily acknowledge that neither they nor their conventions have a
comparative advantage in valuing a business. The role of corporate financial reporting is to provide
useful information for estimating value.
Two fundamental steps—revenue recognition and matching expenses with revenue—determine
earnings. A company recognizes revenue when it delivers products or services and can reasonably
establish the amount that it will collect from customers. It then expenses the costs needed to generate that
revenue during the period in which it recognizes the revenue. In other words, it matches expenses with
revenues. This matching principle is easy to grasp in concept but hopelessly arbitrary in implementation.
Accounting standards give companies latitude in revenue recognition, depreciation methods, and
Does that mean that we shouldn’t value stocks with discounted cash flow? Certainly not. After all, the
returns that investors receive when they purchase any financial asset depend on the cash flows that they
pocket while owning the asset plus their proceeds when selling it. John Bogle argues for discounted cash-
flow valuation: “Sooner or later the rewards must be based on future cash flows. The purpose of any
stock market, after all, is simply to provide liquidity for stocks in return for the promise of future cash
flows, enabling investors to realize the present value of a future stream of income at any time.”3
Extensive empirical research demonstrates that the market determines the prices of stocks just as it
does any other financial asset. Specifically, the studies show two relationships. First, market prices
respond to changes in a company’s cash-flow prospects. Second, market prices reflect long-term cash-
flow prospects. As noted in chapter 1, companies often need ten years of value-creating cash flows to
justify their stock price. For companies with formidable competitive advantages, this period can last as
long as thirty years.
Yet most money managers, security analysts, and individual investors avoid the difficulty of
forecasting long-term cash flows altogether. Instead, they focus on near-term earnings, price-earnings
multiples, and similar measures. Such measures can help identify undervalued stocks only when we can
rely on them as proxies for a company’s long-term cash-flow prospects. But static measures of near-term
performance do not capture future performance, and ultimately they let investors down—especially in a
global economy marked by spirited competition and disruptive technologies. Without assessing a
company’s future cash-flow prospects, investors cannot conclude that a stock is undervalued or
overvalued.
The preceding relationships describe the standard discounted cashflow process, which estimates cash
flows to determine shareholder value. In contrast, expectations investing reverses the process by starting
with price (which may differ from value) and determines the implied cash-flow expectations that justify
that price.
SUMMARY ILLUSTRATION
To calculate shareholder value in the following example, we start with operating value driver
assumptions and end with shareholder value. The expectations investing process operates in reverse: It
starts with market value and solves for the price-implied expectations. The mechanics are the same going
in either direction.
Assume that last year’s sales were $100 million and that you expect the following value drivers to be
constant over an entire five-year forecast period:
Sales growth rate 12%
Operating profit margin 10%
The company’s cost of capital is 10 percent, and the expected inflation rate is 2 percent (see equation
2-7). We calculate the shareholder value added for this set of assumptions in the “10 percent margin”
column in table 3-1. In the next column, we substitute the 9.29 percent threshold margin for the 10 percent
operating profit margin.11 As a result, shareholder value added drops to zero.
The threshold margin draws out four guiding principles that can help you determine when expectations
changes affect shareholder value:
1. If operating profit margin expectations are well above the threshold margin, then positive revisions
in sales growth expectations produce large increases in shareholder value. The larger the revisions,
the larger the increases.
2. If operating profit margin expectations are close to threshold margin, then revisions in sales growth
expectations produce relatively small changes in shareholder value unless the revisions also induce
significant expectations revisions in sales mix, operating leverage, or economies of scale.
3. If operating profit margin expectations are significantly below the threshold margin, then positive
revisions in sales growth expectations reduce shareholder value unless there are offsetting
improvements in operating profit margin or investment rate expectations.
4. A rise in expectations in the incremental investment rate increases the threshold margin and thereby
reduces the value that sales growth adds.
The wider the expected spread between operating profit margin and threshold margin and the faster
the sales growth rate, the more likely that sales is the dominant trigger. When changes in sales also trigger
the other value factors—price and mix, operating leverage, and economies of scale—the likelihood rises
even more.
When do cost or investment value triggers dominate? For companies that earn returns close to the cost
that information links all the steps in a value chain: It is the glue that holds them together. Evans and
Wurster also emphasize that the economic characteristics of information and of physical goods differ.5
The explosion in technology allows for a separation between information and physical goods, leaving
some businesses—especially incumbents—potentially vulnerable. For example, an Internet-based retailer
can offer substantial information content on the Web and still maintain lean physical inventories. So when
a company can separate information and products, it can “deconstruct” the value chain. Slywotzky and his
colleagues dub this division of activities “the great value chain split.”6
Evans and Wurster cite the newspaper industry as a prime example of deconstruction.7 The risk to the
business is not electronic newspapers, or even the news customization that the leading Internet portals
provide. The threat of deconstruction lies in the migration of classified advertising—the most profitable
activity in the newspaper value chain—to the Internet. Without the benefit of classified advertising
revenue, other supporting activities like content, printing, and distribution are unattractive.
• Technology rich. Many fast-moving businesses have trouble embracing the next technology
wave.
• Market leaders. These companies listen to their customers and focus on current profits. As a
result, they often miss significant technological shifts.
• Organizationally centralized. When companies centralize their decision making, they have
difficulty seeing disruptive technologies emerge.
Christensen argues that many companies fail to retain their leadership positions even though great
managers are making sound decisions based on widely accepted management principles. Hence the
dilemma. His framework is based on three findings:
First, sustaining technologies and disruptive technologies are quite distinct. Sustaining technologies
foster product improvement. They can be incremental, discontinuous, or even radical. But sustaining
technologies operate within a defined value network—the “context within which a firm identifies and
responds to customers’ needs, solves problems, procures input, reacts to competitors, and strives for
profit.”9 In direct contrast, disruptive technologies offer the market a very different value proposition.
Products based on disruptive technologies may initially appeal only to relatively few customers who
value features such as low price, smaller size, or greater convenience. Furthermore, Christensen finds that
these technologies generally underperform established products in the near term. Thus, not surprisingly,
leading companies often overlook, ignore, or dismiss disruptive technologies in the early phases of the
technology.
Second, technologies often progress faster than the market demands. Established companies
commonly provide customers with more than they need or more than they are ultimately willing to pay for.
This allows disruptive technologies to emerge, because even if they underperform the demands of users
today, they become fully performance-competitive tomorrow.
Finally, passing over disruptive technologies may appear rational for established companies, because
disruptive products generally offer low margins, operate in insignificant or emerging markets, and are not
in demand by the company’s most profitable customers. As a result, companies that listen to their
customers and practice conventional financial discipline are apt to pass on disruptive technologies.
Certainly, companies should not stop listening to their customers; doing so would be at odds with the
customer-centric value chain. Rather, companies must both meet their customers’ needs today and
anticipate their needs for tomorrow. Sometimes, customers themselves don’t know which products or
services they will want. Given that disruptive technologies may provide tomorrow’s customer solutions,
companies must always balance what works now and what might work in the future, because today’s
solutions may quickly become obsolete. As Intel’s Andy Grove puts it, “Only the paranoid survive.”10
The retail book industry is an example of a disruptive technology in action.11 At the time of
Amazon.com’s initial public offering (IPO) in May 1997, leading book retailers Barnes & Noble and
Borders were significantly improving their standard bookselling business model by rolling out
superstores. These stores offer unprecedented convenience, prices, assortment, service, and ambience—
important sustaining technologies. In contrast, Amazon.com offers a different experience. It quickly
improved the customer proposition along several important dimensions, including assortment, price, and
convenience. Amazon didn’t beat the traditional booksellers at their own game. It completely redefined
the game and launched a new value network.
The Amazon strategy also created a massive shift in expectations—and hence market capitalizations.
From its IPO to early 2001, Amazon’s market capitalization rose by about $5 billion. During that same
period, Barnes & Noble and Borders saw their combined market capitalizations shrink by some $400
million.
Disruptive technologies caused investors to lower expectations for some of the world’s best-known
companies, including Digital Equipment, Merrill Lynch, and IBM. They have also helped create new and
valuable businesses, although business innovation and value creation are not always synonymous.12 You
should be alert for the emergence of new value networks and the seeds of expectations changes that they
sow.
• High up-front, low incremental costs. Many knowledge products are very costly to create the
first time. Once in digital form, however, they are relatively inexpensive to replicate and
distribute. Take software. Microsoft spent about $2 billion to create the first Windows 2000
disk. But replicating and distributing that disk was extremely cheap. As a result, Microsoft has
enjoyed “increasing returns.”14 Every incremental unit of a knowledge product that a company
sells amortizes the fixed, up-front cost. Thus, knowledge-based companies enjoy increasing, not
diminishing, returns. Nevertheless, the heightened pace of new innovation virtually assures that
increasing returns are short-lived. In brief, the high up-front, low incremental costs of
knowledge goods, coupled with technology-driven demand shifts, can lead to explosive, albeit
often short-term, value creation.
• Network effects. Network effects exist when the value of a product or service increases as more
members use that product. As an example, online auctioneer eBay is attractive to a user
precisely because so many buyers and sellers congregate there. In a particular category, positive
feedback typically assures that one network becomes dominant: eBay has not only weathered
competitive onslaughts but strengthened its position. So as winner-take-all markets develop,
variability increases as industry profits migrate to the dominant player. Expectations for the
winner rise just as expectations for the losers deflate.
• Lock-in. Once customers develop user skills with a given product, or set corporate standards
for a product, they often hesitate to switch to a competing offering, even if a rival product
performs better. Hence, the company has “locked in” customers, making them more open to
purchasing highly profitable product upgrades than they are to purchasing products from other
sources. Shapiro and Varian cite multiple forms of lock-in, including brand-specific training and
loyalty programs.15
When information companies enjoy these three advantages, they usually have developed certain
related strategies. When you evaluate knowledge-based companies, be sure to investigate how they rely
on the following:
• Giveaways. In spite of the heavy up-front costs of knowledge goods, a company’s ability to
establish a large user base as quickly as possible increases the potential of building a valuable
network and locking in customers. Hence, giving away products (or heavily discounting them) in
the short term is often the best way for a company to build long-term value.
The implicit understanding in the give-it-away strategy is that established users will be
valuable to the company as a source of future revenues, through product upgrades, ancillary
products, or marketing. One example is Hotmail, a free e-mail service. Hotmail garnered 1
million users within six months of its 1996 launch. After eighteen months, it was up to 12
million users and, by the summer of 2000, had over 45 million users. Each user fills out a
detailed demographic profile, which contributes to a valuable database that attracts advertisers.
Hotmail then sells advertising on its Web site. Microsoft validated Hotmail’s give-it-away
strategy by buying the company in 1997 for approximately $400 million.
• Link-and-leverage. You should also watch link-and-leverage, economist W. Brian Arthur’s term
for the transfer of a user base built on one node of technology to one built on neighboring nodes.
Once customers become accustomed to a given technology or interface, link-and-leverage
becomes a powerful way to create value. Microsoft’s product evolution from operating systems,
to applications, to Internet access is one example. Link-and-leverage highlights the value of real
options, a topic we take up in chapter 8.
• Adaptation. Adaptation is more valuable than optimization. Many mature physical businesses
are optimizers—they perpetually improve their processes to enhance value. Knowledge
some additional guidance:3
VALUING ESOS
The common practice of ignoring ESOs isn’t acceptable, because it can lead to a significant
underestimation of costs and liabilities. Past ESO grants are a genuine economic liability—investors
should treat them like debt. And future option grants are an indisputable cost of doing business.
Before we present the steps involved in valuing options, let’s look at six basic factors that affect
option value: current stock price, exercise price, stock-price volatility, time to expiration, risk-free
interest rate, and dividend yield.
• Current stock price. The payoff to the employee is the positive difference between the stock
price and the exercise price on the date that the employee exercises his or her options.
Companies almost always establish the exercise price, the price at which an employee can buy
the company’s stock, at the market price on the date of grant; the exercise price remains fixed
over the entire option life, usually ten years. Options are available for exercise after employees
become vested, typically three to five years after the grant date.
• Exercise price. Options become more valuable as the stock price increases and less valuable as
the stock price decreases. But even if the stock price falls below the exercise price, options can
retain some value. This value stems from the next two factors—volatility and time to expiration.
• Stock-price volatility. Volatility—expressed as standard deviation—is a measure of the
uncertainty of future stock-price movements. Higher stock-price volatility increases option
value because the stock price is more likely to rise well above the exercise price.
• Time to expiration. How long until the option expires also affects ESO value. The longer the
time to expiration, the greater the chance that the stock price will increase, and, therefore, the
more valuable the option.
• Risk free interest rate. The yield on short-term U.S. treasury securities is a proxy for the risk-
achieving growth targets is critical, the company must not open new stores so quickly so as to cannibalize
sales at existing stores. Meeting new-store targets is so important that a one-year delay in scheduled
openings reduces The Home Depot’s value by almost 16 percent. Two leading indicators—growth in new
stores and revenue per store—largely determine The Home Depot’s sales growth rate and expectations
revisions for shareholder value.
PITFALLS TO AVOID
We all occasionally fall into psychological traps that keep us from achieving higher investment returns.
These traps materialize when we use rules of thumb, or heuristics, to reduce the information demands of
decision making. While heuristics simplify analysis, they can also lead to biases that undermine the
quality of our decisions. Often, intuition suggests a course of action that more deliberate analysis proves
to be suboptimal. Be sure to avoid two common pitfalls—overconfidence and anchoring—when you
establish the range of potential expectations revisions. Let’s look at these pitfalls more closely.
In the words of Will Rogers, “It’s not what we don’t know that gets us into trouble, it’s what we know
that ain’t so.” Researchers find that people consistently overrate their abilities, knowledge, and skill,
especially in areas outside their expertise. For example, when security analysts responded to requests for
information that they were unlikely to know (e.g., the total area of Lake Michigan in square miles), they
chose ranges wide enough to accommodate the correct answer only 64 percent of the time. Money
managers were even less successful, at 50 percent.2
Remember the overconfidence trap when you estimate the high and low scenarios for sales growth as
part of the initial step in the three-step search for expectations opportunities. Overconfidence in setting the
ranges can cause you to misidentify the turbo trigger. An unrealistically broad range overestimates the
shareholder-value impact of sales growth variability, leading you to misidentify sales as the turbo trigger.
If your estimated range is too narrow, the reverse is true—you may choose one of the other two triggers
(costs or investments) when, in fact, you should select sales. When you estimate inappropriate ranges and
unrealistically high or low shareholder values, you get misleading buy and sell signals.
How can you avoid overconfidence? There are several simple, practical ways:
The second pitfall is anchoring, that is, giving disproportionate weight to the first information you
receive. As a result, initial impressions, ideas, estimates, or data “anchor” your subsequent thoughts.
Hersh Shefrin cites an apt example: security analysts who revise expectations after corporate earnings
announcements. Shefrin suggests that analysts do not revise their earnings estimates enough to reflect new
information, because they are anchored on past views. Thus positive earnings surprises lead to more
positive surprises, and negative surprises lead to more negative surprises.3
One of the most common anchors is a past event or trend. In considering high and low ranges for sales
growth, don’t give too much weight to historic results at the expense of more salient factors, especially
when you analyze companies undergoing rapid change. Stock price is another anchor that creates a major
pitfall for investors. Investors often consider a stock cheap if it is at a low point in its trading range and
expensive if it is at the high end. So even if the current fundamental prospects of a company justify a
change in value, investors often have trouble erasing historical prices from memory.
How do you avoid anchoring? You can take some of the following precautions:
Competitive Analysis
Thinking about the potential for expectations revisions for Gateway’s stock, we consider three strategic
frameworks: five forces, value chain, and disruptive technology. The five forces and value chain apply
because the PC industry is well defined and has easily distinguishable operational activities. The
disruptive-technology framework highlights the rapid technological change affecting the industry.
Although the PC enjoys a dominant position today, its future is far from assured.
Let’s begin with how the five forces may affect expectations:
• Barriers to entry. On the surface, barriers to entry do not appear particularly high in this
assembly-based business.However, replicating the market leaders’ brand strength and
operational scale is difficult. Further, Gateway is a leader in the home and small-business
markets and has developed specific customer channels to best serve its markets. Threats of new
entrants into Gateway’s space do not look ominous. These factors point to relatively low
variability in its future operating performance.
• Substitution threat. For Gateway, the substitution threat comes mainly from new technology:
The PC might lose its central position. This threat, though lurking, has yet to materialize at the
time of this analysis in April 2000.We discuss this point in greater detail as part of the
disruptive-technology framework.
• Buyer power. The buyers of Gateway’s products—both individual and corporate—are a
relatively segmented group, and as such none has significant bargaining power. The PC market,
however, is very price competitive, particularly during periods of softening demand. Gateway’s
trusted brand and low-cost, build-to-order business model make its pricing structure appear to
be sustainable. These factors suggest modest variability.
• Supplier power. Although Gateway deals with many suppliers, about a dozen account for 80
percent of the company’s direct material purchases. Yet supplier power does not appear to be a
major threat, because all components are industry standard. Thus, despite more than one-half
million potential product configurations, the company can procure materials at a competitive
price, maintain lean inventories, and still assure that the necessary components are available as
required. Again, variability appears muted.
• Rivalry among competitors. Rivalry among competitors in the industry has not been fierce
enough to undermine industry profitability. Some of Gateway’s competitors—including Compaq
and IBM—have heavily discounted their products from time to time to move excess inventory.
But these companies deal primarily with large corporations. Gateway escaped these periods
relatively unscathed because its target market and business model are sufficiently different from
those of the industry titans. Given the competition’s significant financial resources, however,
potential variability from rivalry is at least moderate and may intensify.
Next we consider variability in the context of value chain analysis.5 We can use the modern value
chain as a guide to evaluate Gateway’s activities (figure 6-3). Gateway’s customers are predominantly
individuals and small businesses, and its customer priorities include the following:
• Sales assistance
• Flexible configuration options
• Easy and fast ordering and delivery
• Total hardware, software, and financial solutions
• Life-of-machine technical support
THE SELL DECISION
You might choose to sell for three potential reasons:
1. The stock has reached its expected value, and your updated, expected value estimate is lower
than the stock price. A note of caution is in order here. Investing is a dynamic process.
Expectations are a moving target that you must periodically revisit and revise. Investors who
mechanistically sell shares just because they reach an out-of-date target price potentially sacrifice
significant returns. Selling because a stock has reached its expected value only makes sense if your
most recent analysis leads you to expect no further upside.
2. Better opportunities exist. Investors who actively manage their portfolios will ideally choose to
hold the stocks that are most attractive today. Consequently, they embark on a never-ending search
for the stocks that trade at the largest discounts relative to their expected value.
The availability of more attractive stocks than those currently in the portfolio gives rise to the
second reason to sell. This decision rule is different from the first one because you do not have to
presume that stocks reach their expected values to sell.
Basically, as long as you maintain your targeted level of diversification, you should consider
selling a stock in your portfolio with a higher price/expected-value ratio and use the proceeds to
buy a stock with a lower price/expected-value ratio. In the next section, we will show how taxes
affect your decision to sell.
3. You have revised your expectations downward. Sometimes, even thoughtful and detailed analysis
misses the mark. At other times, unanticipated events prompt you to change your expectations—and
sometimes materially. If a downward revision in your expectations results in an unattractive
price/expected-value relationship, the stock becomes a sell candidate.
You also need to avoid certain pitfalls when selling stocks. For example, people are very averse to
losses when making choices between risky outcomes, no matter how small the stakes. Daniel Kahneman
and Amos Tversky find that a loss has about two and a half times the impact of the gain the same size.6 In
other words, people feel a lot worse about losses of a given size than they feel good about a gain of
similar magnitude.
Because investors don’t want to take a loss, they tend to sell their winners too soon and hold on to
their losers too long. All investors, including those who adopt the expectations investing approach, should
try hard to sidestep this trap.
Terrance Odean confirms the loss-aversion phenomenon in a study of 10,000 accounts at a large
discount-brokerage firm.7 He finds that investors indeed realize their gains more readily than their losses.
And the winning investments that investors chose to sell continue to outperform the losers they hold on to
in subsequent months. The moral is that we risk making poor decisions when we rely on purchase price as
the frame of reference.
Another pitfall to avoid is the confirmation trap. Investors often seek out information that supports
their existing point of view while avoiding information that contradicts their opinion. This trap not only
affects where investors go for information, but also influences how they interpret the information they
receive. After purchasing a stock, investors often fall into the confirmation trap by seeking evidence that
confirms their thesis and dismissing or discounting information that refutes it.
We have found one technique particularly useful for managing the confirmation trap in the expectations
• Before you decide to sell a stock, consider the important role of taxes and transactions costs.
• Beware of behavioral traps before you buy or sell.
commitment to the strategy. For example, a company that enters a new geographic market may
build a distribution center that it can expand easily if market demand materializes.
• An initial investment can serve as a platform to extend a company’s scope into related market
opportunities. For example, Amazon. com’s substantial investment to develop its customer base,
brand name, and information infrastructure for its core book business created a portfolio of real
options to extend its operations into a variety of new businesses.
• Management may begin with a relatively small trial investment and create an option to abandon
the project if results are unsatisfactory. Research and development spending is a good example.
A company’s future investment in product development often depends on specific performance
targets achieved in the lab. The option to abandon research projects is valuable because the
company can make investments in stages rather than all up-front.
Each of these options—expand, extend, and abandon—owes its value to the flexibility it gives the
company.
As many investors and managers know, a project with zero net present value—the present value of the
future cash flows equals the current outlay to achieve those cash flows—may still have significant value.
Flexibility is often the additional source of value.
Flexibility adds value in two ways. First, management can defer an investment. Because of the time
value of money, managers are better off paying the investment cost later rather than sooner. Second, the
value of the project can change before the option expires. If the value goes up, we’re better off. If the
value goes down, we’re no worse off because we don’t have to invest in the project.
Traditional valuation tools, including discounted cash flow, can’t value the contingent nature of the
exploitation decision: “If things go well, then we’ll add some capital.”3
• Real-option value increases as S increases relative to X (scan from left to right on the table), as
volatility increases (scan from top to the bottom), and as option life extends (compare panel A
with panel B).
• Real options are valuable even when S is far below X. (Look at the option values under S/X =
0.50 and S/X = 0.75.) Discounted cash flow ignores this value and undervalues assets with
embedded options.
• Real-option value is bounded. Note that none of the option values in the table exceeds the value
of the underlying asset, S.
Even though table 8-1 is small and compact, it covers a large range of volatility and potential project
values. As a rough point of calibration, consider the following volatility benchmarks:
• The average company has annual stock-price volatility in the range of 40 to 50 percent.
• Pharmaceutical companies have rather low volatility of about 25 percent per year.
• High-tech stocks often have annual volatility of 75 to 90 percent per year.
• Biotechnology and Internet companies have volatility as high as 90 to 125 percent per year.13
We constructed table 8-1 for only two- and three-year options because a company can defer
investments for only a short time in competitive product markets. Options with long lives are often
follow-on options—available only if a company successfully executes the first near-term option. The
value of these follow-on options is generally only a small fraction of the near-term real-options value.
• First, there must be a high level of uncertainty, or volatility of outcomes. Industries with low
volatility have scant real-options value. For example, consulting firms are low-volatility
businesses. Because they essentially sell labor by the hour, they find it difficult to generate huge
upside surprises.
• The management team must have the strategic vision to create, identify, evaluate, and nimbly
exploit opportunities in a dynamic environment. The existence of real options doesn’t guarantee
that a company will capture their value. Speed and flexibility are especially important for
translating real-options potential into actuality. Realoptions success is especially elusive for
larger companies that have many layers of management, which slow the decision-making
process.
• The business must exhibit market leadership. Market-leading businesses tend to get the best
look at potentially value-creating opportunities to expand or extend their business. Companies
like Cisco and Intel, for example, have “proprietary” growth options not available to their
competitors by virtue of their market-leading positions. Market leaders can also reinforce the
proprietary nature of their real options, preserving more of their value for themselves.
Let’s turn now to market-imputed real-options value. This is the difference between the current stock
price and the consensus-driven discounted cash-flow value for the existing businesses.
itself can affect that performance. An important feedback mechanism materializes when stock prices
affect business fundamentals, which is important to consider in expectations investing—particularly for
young, high-technology companies, which depend heavily on a healthy stock price.17
George Soros calls this dynamic feedback loop reflexivity. He sums it up this way: “Stock prices are
not merely passive reflections; they are active ingredients in the process in which both stock prices and
the fortunes of companies whose stocks are traded are determined.”18 We now consider the impact of
reflexivity for start-ups in two critical activities—the ability to finance growth and the ability to attract
and retain key employees.
Financing Growth
Young companies typically depend on equity financing. Those that consistently report below-expectations
performance cast doubts about the viability of their business models. The resulting depressed stock price
makes issuing new shares either unduly expensive or simply not feasible. This situation, in turn, impedes
or eliminates the implementation of the company’s value-creating growth strategies. As investors come to
recognize the problem, the stock price often continues its downward spiral.
This spiral not only restricts the company’s ability to grow; in some cases it leads to bankruptcy or a
takeover at a sharply discounted price.
One such victim was Living.com, a home-furnishings company, which filed for Chapter 7 bankruptcy
in August 2000. According to the company’s CEO, Shaun Holliday, “the recent downturn in the capital
markets has substantially impaired our ability to raise the capital required to achieve profitability.”
Many start-ups rely on acquisitions to build their businesses. And most of them fund the deals with
stock, which is just another way to finance the company’s growth.19 Poor stock-price performance makes
acquisitions for stock either prohibitively costly or simply impossible. Even companies with robust stock
prices should not be beguiled into thinking that issuing stock is without risk. If the market gives a
thumbsdown to one acquisition by decreasing the acquirer’s stock price, it will almost certainly be more
circumspect about future acquisitions.
Ramifications of Reflexivity
What are the implications of reflexivity for expectations investors? First and foremost, investors need to
ask whether they have considered reflexivity in their assessment of expectations for the company.
Uncritical acceptance of a company’s growth strategy, without factoring in the financing risk arising from
poor stock performance, is a recipe for disappointing investment results.
We suggest that, at minimum, you evaluate this outcome as the worst-case scenario when you develop
a stock’s expected value. The probability of this outcome depends significantly on management’s vision
• Knowledge. People are the main source of competitive advantage for knowledge businesses as
well. But rather than tailoring services for individual customers, these businesses use
intellectual capital to develop an initial product, and then reproduce it over and over again.
Software, music, and pharmaceutical companies are prominent examples. Innovation and
shifting tastes assure that knowledge businesses must constantly improve existing products and
create new ones.
Category Characteristics
Fundamental economic tenets apply to all businesses. But the various categories have different
characteristics and hence different paths to expectation revisions.
Investment Trigger and Scalability. Physical businesses must add physical assets, and service
businesses must add people, to support their growth. In other words, the need for additional capacity
triggers reinvestment. This periodic need for capacity limits scalability, or the ability to sustain sales
growth at a faster rate than the growth of costs. In contrast, scalability is high for knowledge companies
because their goods, once developed, are relatively cheap to replicate and distribute.
Netscape founder, Marc Andreessen, considered the scalability distinction between service and
knowledge businesses when he positioned his subsequent venture, Loudcloud. Loudcloud’s plan was to
get into the Web hosting business, a well-populated competitive space. But Andreessen explained that he
wanted a new angle: “The dumb way to do this business would be to try to do what other companies do. .
. . For every customer, we could hire another 10 people to get them up and run them. It would work. But at
the end of the day, there wouldn’t be that much value. The business would only scale by the number of
bodies you could hire. We wanted to do this for hundreds and then thousands of customers without having
to hire that many new bodies.”1 For this reason, Loudcloud designed a scalable business model based on
software, not on people.
So why aren’t all knowledge companies highly scalable? One reason is that the market accepts
relatively few knowledge products. And those that the market does accept often become obsolete quickly.
The perpetual threat of product obsolescence, in turn, triggers a new round of investment.
Bill Gates, Microsoft’s chairman and chief software architect, highlighted the obsolescence risk in a
1998 Fortune interview: “I think the multiples of technology stocks should be quite a bit lower than the
multiples of stocks like Coke and Gillette, because we are subject to complete changes in the rules. I
know very well that in the next ten years, if Microsoft is still a leader, we will have had to weather at
least three crises.”2
Rival versus Nonrival Goods and Protection. Physical and service businesses often enjoy a reduction in
their average unit costs as sales increase, up to a point. Beyond that, unit costs again rise as the company
bids for additional, scarce inputs or gets bogged down in sizeor bureaucracy-induced inefficiencies. This
is a world of decreasing returns.
In contrast, some knowledge companies are free from the limitations that scarce inputs impose,
because the nature of the goods they produce is different. The distinction is between rival and nonrival
goods.3 With a rival good, an individual’s consumption or use reduces the quantity available to others. A
car, a pen, and a shirt are examples. In contrast, knowledge companies produce nonrival goods, which
many people can use at once. The company creates an initial version of the good, often at great cost,
which it can then replicate and distribute relatively inexpensively. Software is the prototype. Since the
increases. For example, a brokerage firm grows by adding new professionals and getting more production
out of its in-place professionals. The level of sales and the number of employees are closely related.
Growth and productivity in assets and people spur sales growth revisions for physical and service
businesses, respectively.
Knowledge businesses are somewhat different. Specifically, two conditions can lead to extraordinary,
and often unanticipated, sales growth for knowledge companies. The first is when a product becomes a de
facto standard, like Microsoft Windows in PC operating systems. Having one standard assures
compatibility among users and allows companies writing complementary applications software to focus
their resources on that standard. Often, companies battle to become a standard, but once one company
pulls ahead, positive feedback leads to eventual market dominance.
Second, demand tends to take off when a company forms a network that reaches critical mass, that is,
the point at which enough people use a product or service to catalyze self-sustaining growth.6 This growth
is the direct result of network effects, which exist when the value of the product or service grows as new
members use it.7 To illustrate, online auctioneer eBay needed a large enough group of buyers and sellers
to get to critical mass. But once it reached that point, eBay became the network of choice. Buyers and
sellers now go to eBay because others are there, and not only are new members valuable to future
adopters, but they also benefit those already in the eBay family.
The pattern of adoption and sales growth for standard-setters and network stewards is similar.
Growth starts slowly at first, but then it increases at an increasing pace. This demand-side-driven
growth is a prime area of expectations revisions for the winners, who gain the lion’s share of the market,
and for losers, who see their potential customers flock to their rival.8
Lest we appear overly enthusiastic about the economics of knowledge companies, let us sound a
warning. For every winner in a winner-take-most market, we see many losers. Like the winners, these
losers shoulder large investment costs. But unlike the winners, they do not generate sufficient revenue to
offset the costs. The challenge, of course, is to separate the winners from the losers.
Sales growth is a function of volume as well as price and mix. Some physical and service companies
can drive sales growth and higher operating profit margins by raising selling prices, improving their
product mix, or doing both. Businesses that offer consumers greater perceived value than their
competitors do can sometimes charge premium prices. Doing so affords them the opportunity to grow
sales faster than costs. Further, some companies enhance their margins by improving their product mix.
However, we know of no companies that have created long-term shareholder value solely by raising
prices or improving mix. Nevertheless, these value factors can be a short-term source of expectations
revisions.
Operating Leverage
All businesses incur preproduction costs, that is, costs incurred before their products or services
generate sales. The significance of preproduction costs, as well as the time between the initial cost
outlays and sales, varies across categories and companies. Preproduction costs are invariably sunk,
however, and companies leverage them only as sales materialize.
Some physical businesses must commit large amounts of capital in advance of sales to have sufficient
capacity to meet expected demand. The near-term result is unused capacity. As a company increases sales
and uses its capacity, it realizes operating leverage as it spreads its preproduction costs over more units.
The result is a reduced average unit cost and higher operating profit margins.
Steel processing is a good example. A new steel facility costs anywhere from $400 million for a mini-
mill to $6 billion for an integrated mill.9 And since it is not feasible to build only part of a steel mill,
companies must invest the entire amount before any sales can materialize. Not surprisingly, capacity
utilization, a rough index of operating leverage, is one of the key performance measures for the industry.
The steel industry is noted for having excess capacity—which is one reason for its dismal performance.
Kirby Adams, president of BHP Steel, puts it succinctly: “We must start focusing on building value and
not building capacity.”10
Most knowledge products have high up-front preproduction costs but relatively modest costs of
replication and distribution.11 Software is a classic example. As we noted in chapter 4, Microsoft spent
about $2 billion developing Windows 2000. But once it created the first disk, the company could
reproduce it at a very low cost. Because the cost of the product is largely fixed, an increase in units sold
lowers the per-unit cost.
Drug development is another knowledge business with high preproduction costs.12 The U.S. Office of
Technology Assessment says it can cost anywhere from $200 to $350 million and take from 7 to 12 years
to move a product through development and final approval by the Food and Drug Administration.13 But
operating leverage is significant as unit demand grows. One estimate shows the average cost of a new pill
declining from $350 million for the first pill to 36 cents for the billionth.14
Operating leverage does not indefinitely expand operating profit margin. Rather, we should view it as
a transitory phenomenon because physical and service businesses need to add capacity when they run out,
and knowledge businesses must develop a new generation of products to avoid obsolescence. But
operating leverage can still be an important source of an expectations revision.
Economies of Scale
As a company grows—whether it be physical, service, or knowledge—it often can generate economies of
scale that reduce its per-unit costs. Companies that successfully capture economies of scale enjoy higher
operating profit margins.
One straightforward example of scale economies is volume purchasing. Larger companies often pay
less for their inputs—from raw materials and supplies to intangibles like marketing and advertising
services— when they purchase in bulk from their suppliers.
The Home Depot, the world’s largest home improvement retailer, demonstrates the power of scale.
The company’s gross margins widened from 27.7 percent in fiscal 1995 to 29.9 percent in fiscal 2000 as
it tacked on more than $30 billion in incremental sales. The company attributed the margin expansion
primarily to a lower cost of merchandising, resulting from product-line reviews and increased sales of
imported products.15 In other words, The Home Depot uses its size to get the best possible prices from its
suppliers. According to industry analysts, the company passes some of the benefit to consumers in the
form of lower prices, and it preserves some of the gain in the form of higher margins. Notably, smaller
competitors do not enjoy the same benefits. The home-improvement industry’s number two player,
Lowe’s, had gross margins 1.7 percentage points lower than The Home Depot’s in fiscal 2000.
Economies of scale reflect a company’s ability to perform activities at a lower cost as it operates on a
larger scale. In contrast, the learning curve refers to the ability to reduce unit costs as a function of
cumulative experience. Researchers have studied the learning curve for thousands of products. The data
show that for the median firm, a doubling of cumulative output reduces unit costs by about 20 percent.16
Benefits from the learning curve, therefore, generate higher operating profit margins.
A company can enjoy significant economies of scale without benefiting from the learning curve, and
vice versa. But frequently the two go hand in hand. If you understand the distinction between the two, you
can better understand past performance and anticipate expectations shifts. For example, if a large
company lowers its costs as a result of scale economies, average unit costs will increase if sales
subsequently decrease. In contrast, if the company lowers its costs as the result of learning, unit costs may
not increase as sales decrease.
The concept of economies of scope, related to economies of scale, is particularly relevant for
knowledge businesses. Economies of scope exist when a company lowers its unit costs as it pursues a
greater variety of activities. A significant example is research-and-development spill-overs, in which the
ideas that arise in one research project transfer to other projects. Companies that increase the
diversification of their research portfolios can often find applications for their ideas better than they could
when their research portfolios were smaller.17
While economies of scale can be an important source of expectations revisions, our experience
suggests that scale benefits often get competed away for all but the leading physical and service
companies. Further, some leaders choose to pass on to their customers the benefits of scale by lowering
prices to drive sales and market share. For knowledge businesses in winner-take-most markets, size does
matter. Because of the demand and cost characteristics of these sectors, first-to-scale advantages can be
substantial and often lead to meaningful expectations revisions.
Cost Efficiencies
The two value factors we just explored, operating leverage and economies of scale, depend on sales
growth. In contrast, cost efficiency is about lowering costs independent of the sales level.
Companies can realize cost efficiencies in two fundamental ways. First, companies can reduce costs
within various activities: They do the same thing, but more efficiently. For example, the Kellogg
Company, the world’s leading producer of ready-to-eat cereal, has been streamlining production and
operations to reduce costs.
In its annual report released in early 2000, Kellogg forecast that this program would generate $50
million in pretax savings for 2000 and years thereafter. The company anticipates that its cumulative cost
savings, from its 1997–2000 initiatives, will total $245 million (table 9-1). To achieve cost savings, the
company had to incur onetime cash outlays exceeding $250 million—to pay for employee retirement and
severance programs.
Service companies often replace people with physical infrastructure to effect cost savings. One
example is retail banking, where the average cost per transaction has plummeted as customers spend less
time interacting with bank tellers and more time using lower-cost automatic teller machines and the
Internet (table 9-2). Since these cost savings are available to most large financial institutions, they quickly
show up as lowered prices of services. Still, expectations opportunities exist with the adoption leaders
and laggards. By staying ahead of the technology curve, first-movers can sustain lower costs than their
competition, allowing for higher profitability.
Knowledge companies primarily achieve cost savings by reducing employee head count. Novell, a
leading provider of network software, is a case in point. Anticipating annual savings of about $100
million, or 10 percent of sales, in 1997 the company reduced its workforce by approximately 1,000
employees, or 17 percent. In the subsequent two years, sales per employee jumped almost 35 percent.
The second way to realize efficiency is to reconfigure the activities themselves. Consumer products
giant Sara Lee Corporation announced a sweeping restructuring plan in the late 1990s. The company’s
largest business at the time was personal products, mainly Hanes hosiery and knit products. The business
include the following:
Sales
• Does the deal lead to a broadened product offering, expanded distribution channels, or improved
geographic scope?
• Can the combined company achieve greater operating leverage from investments already made?
• Does the company have an opportunity to capture economies of scale in areas such as raw-
material procurement and marketing?
Costs
• Can management eliminate redundant activities, including sales, accounting, legal, and
administrative?
Investments
• Does the deal offer asset redeployment opportunities or specific capital management skills that
lead to lower long-term investment needs?
Besides these potential operational synergies, an M&A deal may also lead to lower tax and financing
costs. While all acquirers enter deals with the best intentions, capturing synergies is clearly a challenge
for them. (See sidebar, “The Acquiring Company’s Burden.”)
Fixed-shares offer. Let’s turn to a fixed-shares stock deal. Recall that the SVAR for a stock deal is the
all-cash SVAR of 24 percent multiplied by the Buyer Inc.’s postmerger ownership percentage of 55.5
percent, or 13.3 percent. Assume, once again, that upon the announcement of the merger, Buyer Inc.’s
stock price falls from $100 to $90 per share. Just as with the cash deal, Buyer Inc.’s shareholders have
already borne part of the synergy risk as a consequence of the stock-price decline. The postannouncement
SVAR thus falls to 8.6 percent—the postannouncement cash SVAR of 15.6 percent multiplied by the Buyer
Inc.’s 55.5 percent postmerger ownership percentage.
The selling shareholders, who will own 44.5 percent of the combined company, have also borne their
proportionate share of the fall in Buyer Inc.’s stock price. At Buyer Inc.’s current stock price, only $0.7
billion of the $1.2 billion premium, or 58.3 percent, remains at risk. This 58.3 percent multiplied by
Seller Inc.’s 44.5 percent postmerger ownership yields a premium at risk of 26 percent. The question for
the selling shareholders is whether they want to risk 26 percent of their premium above and beyond the
premium loss they have already sustained.
Fixed-value offer. Finally, let’s consider the same circumstances for a fixed-value offer. If Buyer Inc.’s
current $90 stock price is also the price at closing, the company will have to issue 44.4 million shares,
rather than 40 million shares, to provide the selling shareholders their fixed value of $4.0 billion. As a
consequence, Buyer Inc.’s shareholders will own only 53 percent of the combined company. As Buyer
Inc.’s shareholders bear the entire risk of its 10 percent postannouncement stockprice decline, the
postannouncement SVAR thus falls to 8.2 percent—the postannouncement cash SVAR of 15.6 percent
multiplied by the 53 percent postmerger ownership percentage.
The selling shareholders in a fixed-value offer bear no price risk in the preclosing period. In fact, the
more that Buyer Inc.’s stock price falls, the less synergy risk the selling shareholders assume after the
closing. With a 10 percent decrease in Buyer Inc.’s stock from $100 to $90, only 58.3 percent of the
premium offer ($0.7 billion of the original $1.2 billion) remains at risk. Multiplying that percentage by the
selling shareholders’ 47 percent stake in the combined company yields a premium at risk of 27.4 percent.
Again, the question is whether the selling shareholders want to make a synergy bet with over a quarter of
their premium at risk.
Mergers and acquisitions provide a fertile source of potential expectations opportunities for investors
who can read management signals and assess the economic consequences. Further, although splashy M&A
announcements may quickly fade from many investors’ minds, the tools we’ve presented in this chapter
allow you to analyze a deal’s implications both upon announcement and during the postannouncement
period.
THE GOLDEN RULE OF SHARE BUYBACKS
We’ve developed a golden rule of share buybacks, which you can use as a universal yardstick for
evaluating the economic attractiveness of buyback programs:
A company should repurchase its shares only when its stock is trading below its
expected value and when no better investment opportunities are available.
Let’s dissect this rule. The first part—“a company should repurchase its shares only when its stock is
trading below its expected value”—is fully consistent with the expectations investing process. In effect,
management is a good investor when it buys its shares when price is lower than value. And if
management’s assessment of expected value is reasonable (that is, if price is truly less than value), then
wealth transfers from exiting shareholders to continuing shareholders. As a result, the expected value per
share for the continuing holders increases, which jibes with the notion that management’s objective is to
maximize shareholder value for its continuing shareholders.
The second part—“no better investment opportunities are available”—addresses a company’s
priorities. Buybacks may appear attractive, but reinvesting in the business may be a better opportunity.
Value-maximizing companies fund the highest-return investments first.
The golden rule also has two noteworthy corollaries:
• The rate of return from a buyback depends on how much the market is undervaluing the
stock. If a company’s shares trade below its expected value and exiting shareholders are willing
to sell at that price, then continuing shareholders will earn a return in excess of the cost of
equity. The greater the undervaluation, the higher the return to continuing shareholders.4 The
shareholder rate of return— the return that continuing shareholders can expect— equals the cost
of equity capital divided by the ratio of stock price to expected value.5 For example, say that a
company has a 10 percent cost of equity and is trading at 80 percent of expected value. Dividing
10 percent by 80 percent gives a 12.5 percent rate of return for the continuing shareholders.
Managers and investors can compare this return with alternative investments and rank its
relative attractiveness. This formula also shows that buybacks above expected value generate
returns below the cost of equity.
• A buyback can be more attractive than an investment in the business. Shareholder-value-oriented
management teams understand that they should fund all investments that promise to create value.
But what if a company has no excess cash or borrowing capacity and, to finance a prospective
share buyback, must partially or wholly forgo value-creating investments in the business? A
company should consider a share buyback only when its expected return is greater than the
expected return from investing in the business.6
We now have a way to assess management’s share-buyback decision. But even if management has all
the right intentions, we must judge whether it has based its decisions on a proper understanding of the
market’s expectations. Beware, too, of management overconfidence. Managers almost always believe that
the shares of their company are undervalued, and they rarely have a full understanding of the expectations
embedded in their stock.7 History is littered with companies that bought back “undervalued” shares only
to see business prospects deteriorate and their stocks plummet.
FOUR POPULAR MOTIVATIONS FOR SHARE BUYBACKS
We now look at the four primary reasons that companies cite for buying back their stock. In particular, we
want to separate the wheat from the chaff: the decisions that benefit continuing shareholders from those
that do not—including decisions that actually harm continuing shareholders. We are looking for signals,
with the golden rule as our guide. Wherever companies violate the rule, we’ll explain management’s
apparent rationale.
• O pen-market purchases. In this buyback method, the most widely used by far, companies
simply repurchase their own shares in the open market, as any other investor would. Although
open-market purchases have legal restrictions—such as a limit to the daily volume that a
company can purchase—this method offers the company the greatest degree of flexibility. On the
other hand, open-market purchases convey the weakest signal of management conviction,
particularly when these purchases merely offset the dilution from employee stock options.
• Dutch auction. In a Dutch auction, management defines the number of shares it intends to buy, an
expiration date, and a price range (generally a premium to the market) within which it is willing
to buy. Shareholders may tender their shares at any price within the range. Starting at the bottom
of the range, the company sums the cumulative number of shares necessary to fulfill the program.
All tendering shareholders at or below the “clearing price” receive the clearing price for their
stock. Dutch auctions are generally strong signals, and management can execute them relatively
efficiently.9
• Fixed price tender offers. With this buyback method, management offers to repurchase a set
number of shares at a fixed price through an expiration date. The price is often a significant
premium to the market price, and companies generally tender for a sizable percentage of the
shares outstanding. Shareholders may or may not elect to tender their shares. Fixed-price
tenders, especially debt-financed ones, tend to be powerful, positive signals to the market.10
Open-market purchases emit the weakest signal, whereas Dutch auctions and fixed-price tenders tend
to convey decidedly stronger signals. In the late 1980s, Dutch auctions and fixed-price tenders
represented about 21 percent of announced buyback volume in the United States. In the 1990s, however,
they constituted only 5 percent of the total. Consequently, the relative number of strong-signal
announcements is down sharply.
The circumstances that surround a buyback also affect the interpretation of the signal. In particular, a
few factors point to the strength of management’s conviction that the shares are undervalued:11
• Size of buyback program. All things being equal, the larger the program—the higher percentage
of the float that a company retires— the greater management’s conviction.
• Premium to market price. Sizable premiums reflect not only a belief that expectations are too
low, but also a willingness to act on such conviction.
• Insider ownership. Relatively high insider ownership better aligns the economic interests of
managers and shareholders. Managers with relatively significant equity stakes are more likely to
invest only in value-creating opportunities than to maximize the size of the company.
• Insider selling. When managers execute a sizable buyback program and indicate that they will
not sell any of their shares, they are increasing their personal bet on the success of the company.
This action sends a positive message to the market.
• Fixed value plans, which offer executives a predetermined annual value over the plan period
• Fixed number plans, which stipulate the number of options that executives receive annually
over the plan period
• Megagrants, which are large, up-front grants offered in lieu of annual grants
With fixed-value plans, a company is less likely to lose executives because the plans assure new
options in the succeeding year even if the stock price falls. These plans insulate annual grants from the
company’s performance because executives receive more options if the stock price falls and fewer
options if the stock price increases. Fixed-value plans, while popular, provide the weakest incentives of
the three types of programs. You should be particularly concerned when you find fixed-value plans in
static companies whose executives lack entrepreneurial drive. In such situations do not look for
expectations to be revised upward. More likely, management will end up with a larger piece of the
company while shareholders bear the cost of sustained underperformance.
Fixed-number plans offer a stronger pay-for-performance link than do fixed-value plans because the
value of the annual at-the-money options increases as the stock price rises.4 Likewise, a fall in the stock
price decreases the value of future option grants. With fixed-number plans, a company risks losing
executives, since the value of the prespecified number of shares is smaller if the stock price falls.
Megagrants provide the most powerful value-creation incentive for executives because both the
number of options and the exercise price are fixed in advance. In other words, these grants provide
executives with contingent equity years in advance of hoped-for performance. Although companies do not
offer megagrant plans as frequently as they offer multiyear plans, megagrants are common in Silicon
Valley high-technology companies.
Although megagrants provide a strong incentive to executives at the time of the grant, the incentive
quickly erodes if the stock price drops and the options fall significantly below the exercise price.
Megagrants are particularly risky for high-technology start-ups with volatile stock prices because
retaining executives with underwater megagrants is very difficult in a tight labor market. Ironically, the
most frequent users of megagrants, high-technology start-ups, are precisely those most likely to suffer
employee turnover as a consequence of a falling stock price.
How does all this information fit into your expectations analysis? First, determine which approach a
company uses to grant options. Then assess the trade-off between the strength of the incentive and the risk
of losing executives. A mismatch between the options-grant approach and the company’s circumstances
may signal that you should lower your expectations estimates or establish a higher probability for
your worst-case scenario.
Can companies eliminate most of the limitations of standard stock-option grants? Yes. In fact,
companies can design relatively straightforward option programs that reward exceptional performers
with greater gains than they would achieve with standard options, while appropriately penalizing poor
performers. Expectations investors should be alert to companies that adopt such a program and should
advocate its implementation when possible.
An indexed-option program best aligns the interests of managers and shareholders seeking superior
returns.5 With this kind of option, the exercise price that executives pay is tied either to an index of the
company’s competitors or to a broader market index. For example, if the chosen index increases by 20
percent, then the exercise price of the options increases by the same percentage. The indexed options in
this case are worth exercising only if the company’s shares rise more than 20 percent, outperforming the
index.
Indexed options do not reward underperforming executives simply because the market is rising. Nor
do they penalize superior performers because the market is steady or declining. If the index declines, then
so does the exercise price, which keeps executives motivated even in a sustained bear market.
Significantly, indexed options reward superior performance in all markets.
Despite their appeal and the support of notables such as Federal Reserve Chairman Alan Greenspan
and a growing chorus of institutional investors, indexed options remain a rare species.6 CEOs shun them
company has properly aligned the performance targets and incentive pay for operating-unit executives
with the interests of shareholders.
Stock options, along with annual and long-term financial incentives, account for well over half the
compensation for operating executives. Unfortunately, option plans and financial targets are often
inappropriate incentives. A company’s stock price is not an appropriate performance measure for an
individual operating unit. Such units are essentially private companies embedded in publicly traded
companies. Operating-unit executives usually have a limited impact on the company’s overall success and
hence its stock price. Incentives based on the share price do not give them the rewards they deserve.
A stock price that declines because of disappointing performance in other parts of the company may
unfairly penalize the executives of the superior-performing operating unit. Alternatively, if an operating
unit performs poorly but the company’s shares rise because of superior performance by other units, the
executives of that unit will enjoy an unearned windfall. Only when a company’s operating units are truly
interdependent can the share price be a fair and useful guide to operating performance.
Companies frequently use financial measures such as operating income and return on invested capital
to measure operating-unit performance. These measures do not reliably link to shareholder value,
however. To overcome the criticism that measures of earnings do not incorporate the cost of capital, a
growing number of companies deduct a cost-of-capital charge from earnings. While some consultants and
managers purport that the resulting “residual-income” calculation is a reasonable estimate of shareholder
value added, residual income remains essentially an earnings number with all its shortcomings.7 Even if
residual income were a reasonable measure of performance, companies frequently set the level of
minimum acceptable performance too low.
Management creates value when the returns on incremental corporate investments exceed the cost of
capital. But that does not mean that an incentive system should reward operating executives for any value
creation. Companies that use the cost-of-capital standard as a threshold for incentive compensation
generally ignore the expectations of value creation that a company’s stock price already implies.
Take a company with a 10 percent cost of capital. Say that the share price reflects the market’s belief
that the company will find opportunities to invest at an average expected rate of return of 25 percent. If
managers start to invest in projects yielding less, say 15 percent, then investors will revise their
expectations downward and the company’s stock price will fall. Few would argue that the company
should reward managers for such performance, even though they beat the cost of capital.
How then should the company set incentive pay for an operating unit? To deliver superior returns to
its shareholders, a company’s operating units must collectively deliver value that exceeds the level
implied by the current stock price. The CEO and other corporate-level executives are unlikely to profit
from their indexed options if performance falls below that level. Compensation schemes should therefore
reward operating executives for delivering superior shareholder value added (SSVA® ).8
If a company uses the wrong measure of performance or an inappropriate level of threshold
performance, then investors have good reason to question how well the incentives in place motivate
superior value creation. This concern, in turn, should make investors more cautious when they assess the
likelihood of favorable expectations revisions.
11 Share Buybacks
1. Companies finance these programs through internally generated cash flow, cash on the balance sheet, or issuance of debt.
2. As Warren Buffett said in Berkshire Hathaway’s 1984 annual report, “When companies with outstanding businesses and comfortable
financial positions find their shares selling far below intrinsic value in the market-place, no alternative action can benefit shareholders as
surely as repurchases” (Berkshire Hathaway Inc., “Letters to Shareholders 1977–1986,” 85).
3. Michael C. Jensen, “Corporate Control and the Politics of Finance,” Journal of Applied Corporate Finance 4, no. 2 (Summer 1991):
13–33.
4. Companies and investors often incorrectly associate the “return” from a buyback with accounting-based measures, like the inverse of the
P/E multiple. The (faulty) logic is as follows: Say the consensus expects a company to earn $1 per share. The shares trade at $25, a P/E
ratio of 25. So the company gets $1 in earnings for every $25 share it buys back, a “return” of 4 percent (1/25). The flaw in this analysis
is that investors cannot reliably link a P/E multiple to the cost of equity, because multiples are a shorthand that incorporate variables other
than the discount rate. These variables include growth, operating margins, investment needs, and the sustainability of competitive
advantage.
5. Rappaport, Creating Shareholder Value, 96.
6. Reinvestment opportunities range from relatively high returns to returns modestly above the cost of capital. Naturally, management should
target lower-return opportunities for further scrutiny. However, some low-return investments, such as those for environmental controls,
may be regulated, and therefore, investors cannot avoid them. Other investments appear to generate low returns until you consider the
consequences of not investing. Yet other investments may not fully incorporate the benefits to other products or services in rate-of-return
calculations.
7. A month before the market crash in October 1987, Louis Harris and Associates polled 1,000 CEOs. The pollsters asked, “Is the current
price of your stock an accurate indicator of its real value?” Of the 58 percent who responded no, virtually all believed that the market
was undervaluing their shares.
8. Clifford Stephens and Michael Weisbach, “Actual Share Reacquisitions in Open-Market Repurchase Programs,” Journal of Finance
53, no. 1 (1998): 313–333.
9. William McNally, “Who Wins in Large Stock Buybacks—Those Who Sell or Those Who Hold?” Journal of Applied Corporate
Finance 11, no. 1 (Spring 1998): 78–88. McNally shows that the nontendering shareholders who “pay” the tendering shareholders for the
premium through a wealth transfer are rewarded by the market’s positive reaction to management’s positive signal.
10. Ranjan D’Emello and Pervin K. Shroff, “Equity Undervaluation and Decisions Related to Repurchase Tender Offers: An Empirical
Investigation,” Journal of Finance 55 (October 2000): 2399–2324.
11. Theo Vermaelen, “Common Stock Repurchases and Market Signaling,” Journal of Financial Economics 9 (1981): 139–183.
12. A Microsoft press release articulates this point: “The number of shares to be purchased during fiscal 2001 will be based on several
factors, primarily the level of employee stock option exercises” (“Microsoft Announces Share Repurchase Program,” press release, 7
August 2000). http://www.microsoft.com/presspass/press/2000/Aug00/BuybackInitiationPR.asp.
13. Robert O’Brien, “Deals and Deal Makers: Stock Buybacks Gain Popularity, but Price Pops Aren’t Guaranteed,” Wall Street Journal, 6
March 2000.
14. The results are the same if we assume that the companies borrowed to fund the program instead.
15. Eugene F. Fama and Kenneth R. French, “Disappearing Dividends: Changing Firm Characteristics or Lower Propensity to Pay?”
working paper 509, Center for Research in Security Prices, June 2000.
16. Our statements relate to the United States. Other countries have different tax rates and policies.
17. All shareholders on record date are eligible to receive a dividend. The exdividend day is the first day of trading when the seller, rather
than the buyer, of a stock will be entitled to the most recently announced dividend payment. This date is currently two business days
before the record date. A stock that has gone ex-dividend generally trades lower by the amount of the dividend. So when a $100 stock
pledging a $1 dividend goes exdividend, the trading price drops to $99.
18. For a more sophisticated approach, see John R. Graham, “How Big Are the Tax Benefits of Debt?” Journal of Finance 55 (October
2000): 1901–1941.
12 Incentive Compensation
1. This chapter is adapted from Rappaport, “Executive Pay,” 91–101.
2. The exercise price for conventional stock options is the price on the day that the options are granted. It stays fixed over the entire option
period, usually ten years. If the share price exceeds the exercise price, then the option holder can cash in on the gains.
3. Hall, “What You Need to Know,” 121–129.
4. For example, a 20 percent increase on a $100 stock is worth more than the same 20 percent increase on a lower-priced stock.
5. For a detailed presentation of the incentive implications of indexed options, see Shane A. Johnson and Yisong S. Tian, “Indexed Executive
Stock Options,” Journal of Financial Economics 57, no. 1 (2000): 35–64.
6. Level 3 Communications Inc., an operator of fiber-optic phone networks, is the commonly cited exception.
7. For a detailed explanation of the differences between shareholder value added and residual income, see Rappaport, Creating
Shareholder Value, 119–128.
8. For a detailed explanation of how to estimate superior shareholder value added, see Rappaport, “Executive Pay,” 97–99.
business models, 139
buy, sell, hold decisions, 8, 105–116
choosing buy, 110–112
choosing sell, 112–114
expected-value analysis for, 105–108
Gateway case study for, 108–110
taxes and, 114–115
buybacks. See share buybacks
buyer power, 56, 93
capacity
competitor moves and adding, 57
as investment trigger, 137
capital
changes in working, 25–26
investments in working and fixed, 11, 25–27
structure of, 173
time value of, 11
capitalism, xi–xiv
Capital (Marx), xi–xii
cash, excess, 33–34
cash conversion cycles, 46, 97
cash flow
determining, 21, 23
free, 22–28
sources for, 71–72
as stock price basis, 19–21
cash offers, 162, 163–164, 166–167
cash tax rate, as value determinant, 22–23
Charles Schwab & Co., 59
Christensen, Clay, 59, 61
Clark, James, 148
compensation, incentive, 185–195
competitive advantage period, 73
competitive strategy analysis, 51–66
disruptive technology framework for, 61–63
finding expectations opportunities with, 86–90
five forces framework for, 54–57
frameworks for, 53–65
historical analysis, 52–53
information rules framework for, 63–65
uses of, 51–52
value chain framework for, 58–60
competitors, anticipating moves of, 57
compounding, 19
confirmation trap, 114
consensus-tracking services, 71
Copeland, Tom, 148–149
core competencies, 60
corporate value
determining, 21
versus shareholder value, 33–34
cost efficiencies, 89
business categories and, 145–147
as value factor, 44–45
cost of capital, 11, 28–32, 72, 88
opportunities and, 88
weighting, 28–29
costs
as turbo trigger, 87–89
up-front versus incremental, 63
customers
locking in, 64
needs of, 62
priorities of, 59
debt
average, by industry, 28–29
in expectations analysis, 72
share buybacks and, 182–183
shareholder value and, 34
deconstruction, value chain, 60
Dell Computer, 45, 92
demand-flow technology, 147–148
discounted cash-flow model, 2
equity, 32
estimating expectations with, 7
financial service companies and, 32
price setting by, 20
time value of money in, 11
Williams on, 8
discounting, 19
disruptive technology, 61–63, 95
distribution channels, 59, 94
dividends, 181–182
dividend yield, 79
drug development, 143
Dutch auctions, 176
fair disclosure, 3
Fama, Eugene, 181–182
Financial Accounting Standards Board, 78
financial call options, 119–122
financial service companies, 32, 59
five forces framework, 54–57
fixed-price tender offers, 176–177
fixed-share offers, 160–161, 167
fixed-value offers, 161–162, 163, 167–168
flexibility, 119
forecast period, 33
market-implied, 33, 73, 74–76, 88
French, Kenneth, 181–182
Fuji, 57
game theory, 57
Gates, Bill, 137
Gateway
business model, 92, 95
cash flows, 73–74
competitive analysis of, 92–95
cost of capital, 74
expectations opportunities and, 92–104
expected-value analysis of, 108–110
historical analysis of, 95–104
market-implied forecast period, 74–76
nonoperating assets and debt, 74
sales growth at, 101–103
General Electric, 45
giveaways, 64–65
Greenspan, Alan, 190
Gretzky, Wayne, 2
Grove, Andy, 62
growth investments, 6–7
growth strategy, 133–134
Ibbotson.com, 72
incentive compensation, 185–195
threshold for, 192–193
incremental fixed capital investment rate, 25
incremental working capital investment rate, 25
industry attractiveness, 53–54
industry stability, 52–53, 124–125
industry structure, 53
inflation, perpetuity-with-inflation method and, 37–38
information
anchoring, 91
confirmation trap of, 114
in the value chain, 60
information rules framework, 63–65
initial public offerings (IPOs), 182
insider selling, 177
interest rates, 88
Internet, financial services distribution via, 59
inventories, 26
investment efficiencies, 147–149
as value factor, 45–46
investment misconceptions, 9–14
investments
buybacks versus, 174–175
at Gateway, 97
as turbo trigger, 87–89
as value driver, 22–23
management
active investment, 4–7
assessing information from, 71
merger/acquisition signals by, 162–164
objectives of, 51
overconfidence of, 175
real-options analysis and, 125–126
signals in share buybacks, 172–173
synergy estimates of, 155–156
margin of safety, 8, 110–111
market, as short term versus long term, 9–10, 70
market-implied forecast period, 73
finding opportunities and, 88
Gateway’s, 74–76
market-imputed real-options value, 126–127
market leaders, 61, 126
market risk premium, 30, 72
Marx, Karl, xi–xii
McDonald’s, 45, 148
mental accounting, 112
mergers and acquisitions, 153–169
acquiring company burden in, 158–159
anticipating stock market reaction to, 164–168
assessing impact of, 157–162
cash offers, 166–167
fixed-share offers, 167
fixed-value offers, 167–168
management signals in, 162–164
significance of, 153
stock price assessments in, 3
synergy evaluation for, 155–156
value added by, 154–155
Merrill Lynch, 59
Microsoft, 63
ESO value at, 80–81, 82, 83, 84
mix
business categories and, 141–142
as value factor, 42
mutual funds
costs of, 5
incentives for managers of, 5–6
investing styles of, 6–7
versus private investing, 3
tools used by, 5
underperformance of benchmarks by, 4–7
Napster, 138
net operating profit after taxes (NOPAT)
determining, 21, 25–26
in perpetuity calculations, 36–37
residual value and, 26–27
sales growth and, 47
network effects, 63–64, 141–142
Nodine, Thomas H., 89
nonrival goods, 137–138
Novell, 146
Nucor, 44
obsolescence, 137
Odean, Terrance, 114, 115
offerings, 59, 94–95
open-market purchases, 176
operating leverage
business categories and, 142–143
compared to economies of scale, 44
as transitory, 143
as value factor, 42–43
operating profit
determining, 21
at Gateway, 96–97
margin as value driver, 22–23
shareholder value and, 47–48
opportunities, identifying, 7–8, 85–104
Gateway case study, 92–104
pitfalls in, 90–91
searching for, 86–90
options, employee. See employee stock options (ESOs)
options, real. See real-options analysis
overconfidence, 90–91, 115
of management, 175
sales growth
at Gateway, 96, 101–103
as value driver, 22–23
sales triggers, estimating, 87
Santa Clara University, 112
Sara Lee Corporation, 146
scalability, 137
sell decisions. See buy, sell, hold decisions
service companies, 136
Shapiro, Carl, 63
share buybacks, 171–183
circumstances surrounding, 177
versus dividends, 181–182
golden rule of, 173–175
increasing financial leverage with, 182–183
management signals in, 172–173
managing earning per share with, 178–180
motivations for, 175–183
as negative signal, 173
rate of return from, 174
returning cash to shareholders with, 180–182
to signal undervaluation, 175–177
shareholder value. See also mergers and acquisitions
cash flow in, 21–22
versus corporate value, 33–34
expectations changes effects on, 47–48
of Gateway, 99
investment efficiencies and, 147–149
sales trigger and, 87
sample calculation of, 34–35
shareholder value at risk (SVAR), 157–160
Shefrin, Hersh, 91, 112
Sirower, Mark L., 157, 159
Slywotzky, Adrian, 44, 58, 60
software, up-front versus incremental costs of, 63. See also knowledge businesses
Soros, George, 132
Southwest Airlines, 44
stability, industry, 52–53
Standard & Poor’s, 71
start-ups
ESOs and, 80–81, 84
real-options valuation of, 117–118
reflexivity and, 132–134
steel industry, 142–143
stock issuance, 162–163
stock offers, 162, 163–164
stock options. See employee stock options
stock prices, xv–xvii
buy decisions and, 110–111
cash flow impact on, 19–21
corporate value and, 33–34
cost of capital and, 28–32
ESOs and, 79–84
estimating expectations from, 69–84
expectations basis of, 19–21
expectations implied by, 2
forecast period and, 33
free cash flow and, 22–28
how the market creates, 19–38
investing styles and, 6–7
in management decisions, 3
reaction to mergers/acquisitions of, 164–168
reflexivity and, 132–134
shareholder value and, 21–22, 33–35
target, 100
volatility of, 123–124
substitution threat, 55, 93
sunk costs, 111–112
supplier power, 56, 93
synergies, 155–156
evaluating current risk of, 166–167
measuring risk of, 157–162
uncertainty, xii–xiii
increased, 3
real-options analysis and, 125–126
U.S. Office of Technology Assessment, 143
U. S. Securities and Exchange Commission, fair disclosure, 3
user base, establishing, 64–65
value
book versus market, 28–29
corporate, 21, 33–34
earnings growth and, 15–16
expected-value analysis and, 107
of flexibility, 119
indicators of and incentive compensation, 193–194
leading indicators of, 89–90
of project, 120, 123
variability of, 107–108
value chain analysis, 58–60, 94–95
value drivers, 22–23
in expectations revisions, 40–41
historical analysis of, 52, 53
share buybacks and, 173
value factors, 40–46
business categories and, 140–149
competitive strategy analysis and, 52–53
cost efficiencies, 44–45
economies of scale, 43–44
investment efficiencies, 45–46
operating leverage, 42–43
price and mix, 42
volume, 42
value growth duration, 73
Value Line Investment Survey, 71
value triggers, 40–41, 46, 48–49
Varian, Hal, 63
Verlinden, Matt, 59
vertical integration, 58
volatility, 120, 123–125
volume
business categories and, 141–142
as value factor, 42